The Bear’s Lair: Review: David Kynaston’s “A Club No More”

This six-part review of David Kynaston’s book on the post-war City of London was published by UPI in 2002. It reflects my own thoughts at that time on why the City changed, and what went wrong. I stand by the analysis in Parts I-V today, but inevitably some (but not all) of the predictions in Part VI now appear a little eccentric.

Review: Part I — Governors and Chancellors

This is the first part of a six-part reflection and commentary on David Kynaston’s “A Club No More” (Chatto and Windus, $43). It covers the key relationship between the Bank of England, represented by the governor, and the government, normally represented by the chancellor of the exchequer.

The underlying theme is the expansion of the Bank of England’s role in monetary policy.

From 1945 to 1951, the Bank of England was simply the agent of the Treasury, whose policy was not to use monetary levers at all. Since 1997, the bank has had entire responsibility for monetary policy, a level of independence that even the legendarily powerful Montagu Norman (governor, 1920-44) never achieved.

But the bank’s powers have declined on the regulatory side. In the early years after World War II, its power over city banking institutions was more or less absolute and largely exercised over the legendary “cup of tea.”  Since 1996, it has had no power over the banking system.

At the end of World War II, nearly all the city’s traditional markets were closed (apart from much of the existing infrastructure that had been bombed to rubble.) Share trading was allowed only on a cash basis, with no “contangos” allowing positions to be carried forward between the two-week account periods. There was no options trading either, though there had been an active market in share options from the 19th century to 1939.

Commodity cash and futures markets were closed, since commodity trading was felt to be a means where the city could evade Whitehall’s prohibitions against acquiring foreign currency. Even the gold market was closed and the two top partners in one of London’s leading gold dealers founded an industrial clothing company to await the return of the market.

The discount market, trading in short-term debt, was dormant because Whitehall didn’t believe in using the interest rate mechanism to affect the economy.

So it’s difficult to see how the city could have been anything but “moribund” in Kynaston’s term. It’s surprising that many of its capabilities survived at all.

One remarkable feature of the early post-war years was the low level of financial understanding in Whitehall and its high level of hostility toward the city. Hugh Dalton, chancellor of the exchequer from 1945 to 1947, was a son of the dean of Windsor and graduate of Winchester public school who despised the city and had great difficulty negotiating with Bank of England Governor Thomas, Lord Catto, who had started at 16 as a Scottish bank clerk. As Catto said in his memoirs, “My relations with Mr. Dalton were most delicate, but very cordial.”

Dalton based his work on one of John Maynard Keynes’ more peculiar theories: If interest rates could be driven low enough, the result would be the desirable “euthanasia of the rentier.” Instead of the evil rentier, industrial capital was to be provided by a state-funded National Investment Board. In 1945, the Industrial and Commercial Finance Corporation was set up by five London clearing banks (retail commercial banks.)

Dalton implemented this theory by refunding a vast chunk of government debt into the infamous Daltons, Treasury 2.5  percent due after 1975, which did indeed, when combined with Dalton’s inflationary public spending policies, slaughter the savings of a vast number of modest British rentiers (though there was very little mercy about the euthanasia.)

Following Dalton’s forced removal in 1947, the policies changed somewhat, but the level of understanding in Whitehall didn’t. Catto’s successor, Cameron Cobbold (governor, 1949-61), saw an opportunity to break out with the return of a conservative government in October 1951.

The futuristically named “ROBOT” plan of 1952, where Britain would abandon the restrictive Bretton Woods agreement, restore the full convertibility of sterling, and remove exchange controls, returning largely to the free market and allowing the city and indeed the British economy as a whole to reawaken, was supported strongly by Cobbold and the chancellor of the exchequer, Richard “Rab” Butler. But it was defeated in the cabinet.

“ROBOT’s” principal opponents were Winston Churchill, prime minister, and his two successors, Anthony Eden and Harold Macmillan. All three were proud members of Whitehall’s financial illiteracy club.

As a consequence, the opportunity was lost. Meat rationing remained in Britain until 1954, the gold market and foreign exchange markets were closed until 1958, option dealing was banned until 1958 (the 19-year gap from 1939 ensured that it had to be essentially reinvented), foreign exchange controls on investment abroad remained until 1979, and the top rate of income tax remained at 75 percent or higher until 1979. Not surprisingly, there was no wirtschaftswunder in Britain until the 1980s.

Following the failure of ROBOT, Tory chancellors attempted to control the economy by means of monetary policy, implemented by the Bank of England but wholly dictated by Whitehall. There was little attempt to control public spending, other than a brief flicker of hope under Chancellor Peter Thorneycroft in 1957-58, which was snuffed out by his forced resignation and the resumption by Macmillan of control over economic policy.

Macmillan was certainly no free marketer. In “The Middle Way” in 1938 he’d advocated abolishing the stock exchange altogether (the middle way between what and what, one is forced to ask?).  As late as the last days of his premiership, in October 1963, when Barclays was worried by evidence of economic overheating in the notorious Maudling reflation and tried to raise its overdraft rate by 0.5 percent, Macmillan said “This is very serious. Why not nationalize the banks?”

The Bank of England’s own attitudes remained firmly committed to the free market and to a unique methodology for managing the city’s diverse institutions and personalities. An internal “Maxims for Central Bankers” of 1962 noted:

“All expenditure is inflationary, but government expenditure most of all.”

“Stability in the value of money helps economic growth.”

“Taxes are too high.”

“No civil servant understands markets.”

“Politicians do not sufficiently explain the facts of life to the electorate.”

“A central banker needs a sense of smell.

Analysis is only theorizing but may be encouraged when it confuses critics.”

In 1961, Cobbold was succeeded by the Bank of England’s true postwar hero, Rowley Baring, Earl of Cromer. Only 42 when appointed in 1961, a former Guards colonel and partner in the family merchant bank, he took Cobbold’s gentlemanly resistance to Treasury monetary policy to an altogether new level.

After Labor’s win in October 1964, Baring repeatedly defied the government over the issue of the policies necessary to maintain sterling’s $2.80 parity. At the same time, he obtained last-minute loans, in one case of $3 billion, to make it happen.

In discussions with both the middle class Tory Selwyn Lloyd and subsequent Labor chancellors, Baring showed none of Dalton’s upper middle-class guilt complex when dealing with his social inferiors, but got on quite well with them. Blue-collar stalwart Jim Callaghan, chancellor of the exchequer 1964-67, was fond of referring at parties to the opinions of his new friend “Rowley,” thus mystifying his colleagues in the Labor movement.

When faced with academic pretensions, however, Cromer was implacable, commenting on a memorandum of the government’s advisor, Hungarian economist Nicholas Kaldor: “It is because Britain has followed policies diametrically opposite to the philosophy of this paper that the pound became universally respected. I feel ashamed to read such a paper on HM Treasury stationery.”

The other part of Cromer’s achievement, with even more long-term significance for the city, was the rise of the Eurobond market. Warburg’s, not the Bank of England’s favorite house (Sigmund Warburg was totally lacking in a sense of humor) did the first such issue, a $15 million, 15-year bond for Autostrade, the Italian motorway, in 1963.

Cromer was highly encouraging in removing obstacles.

“It is par excellence an example of the kind of business which London ought to be able to do both well and profitably,” wrote his deputy, with Cromer’s endorsement. Cromer’s long-term ambition, which was not realized in his time, was to remove exchange controls and return London to its pre-1914 pre-eminence

“Cromer still thinks of a great liberalization of the capital market, whether we are in the EEC or not, as an important step forward,” Sir Alec Cairncross of the Treasury wrote disapprovingly.

Cromer’s gallant resistance to the forces of socialism and financial illiteracy marked the post war high point in the influence of the Bank of England. It was the only time since Montagu Norman that the man in the street could name its governor.

More important, in coming half way — or even a quarter of the way — toward meeting Cromer’s imperious tirades, the Labor chancellors of the exchequer and the Treasury mandarins at last began to move toward financial literacy.

Jim Callaghan and Roy Jenkins, chancellor from 1967 to 70, were both far ahead of their predecessors, both Tory and Labor (with the possible exceptions of Butler, who lost the argument, and Thorneycroft, who didn’t last.)

From these years on, Whitehall began once more, as before 1914, to have an understanding of the primary importance of the city of London in the British economy, and of city expertise as key to successful economic management. There would be something of a relapse under the anti-city Heath and the feeble Barber, but never again would outright hostility break out, as it had under Dalton and Macmillan.

That, in the end, was Cromer’s legacy. Of course his gallant resistance to 1960s corporatism was too good to last. After Labor was reelected with a large majority in March 1966, it was clear that he would not be re-nominated for a second five-year term.

Deputy governor Leslie O’Brien was Cromer’s choice as successor. O’Brien was a “safe pair of hands” who shared most of Cromer’s views, but inevitably his influence was less. Nevertheless, from Cromer’s tenure onward, the principle was once again established: The Bank of England bore primary responsibility for monetary policy.

The “Barber boom” from 1971 to 1973 and the “Lawson boom” from 1987 to 1988 repeated Maudling’s reflationary mistake of the early 60s, but with Callaghan close to ultimate power after 1974 and Jenkins fondly remembered, Bank of England control over monetary policy was fairly easily re-established.

In the other direction toward over-stringency, Robin Leigh-Pemberton, governor from 1983 to 93, supported Britain’s entry into the exchange rate mechanism in 1990 at a sterling parity that had been artificially ramped up by the Treasury. It bears much of the responsibility for the subsequent disaster. However, in spite of the Bank of England’s monetary pre-eminence, blame for the fiasco fell largely on the Treasury, and the luckless John Major and Norman Lamont.

The final move was the full independence of the Bank of England granted by the incoming Blair government in 1997. Since then, the bank has pursued an uncontroversial course, albeit in easy times, leaning gently against any attempt for Britain to join the euro.

As the bank acquired more influence over monetary policy, however, it lost influence over the city’s financial service businesses. What had been immediate acceptance of bank dictates in Cromer’s day became sullen acquiescence at the time of the secondary banking crisis of 1973-74, and steadily decreasing Bank of England power thereafter.

Gordon Richardson (governor 1973-83), who as an ex-chairman of Schroders merchant bank might be thought to have had Cromer-like capabilities, turned out an indecisive bureaucrat, hobbled by his legal training. Leigh-Pemberton, a clearing banker, was not expected to be a strong governor, but simply a reliable tool of the Thatcher government in monetary and regulatory policy. He was neither. Eddie George, governor since 1993, suffered the Barings fiasco early in his term and was thus in a poor position to resist the second (1996) Financial Services Act, which removed the Bank of England’s regulatory powers altogether.

The city’s changes after 1966 will be discussed in parts II through V.  In the meantime, I end with one thought: Had Cromer been reappointed in 1966, and had he continued like Montagu Norman for term after term (he lived until 1991), he still would have been only in his late 60s at the time of the 1986 “Big Bang” city revolution.

Can anybody doubt that, with a Bank of England governor as knowledgeable and determined as Cromer, the history of Big Bang would have been very different and the city would still today be dominated, as it was in the 1960s, by London merchant banks?


Review: Part II — Social and structural upheaval

This second part covers the social and structural revolution in the stock market (brokering and jobbing) and in Lloyd’s Insurance, when both markets ceased to be “gentlemen’s clubs” but failed to compete entirely successfully at the highest international level.

With which of these two Old Etonian stockbrokers, from quotations in Kynaston’s book of 1967 and 1984, would you rather do business?

“Do I work hard?  Well, frankly, no.  I get down to the office after the rush hour — about 10:15 — and I leave just before it, about 4 o’clock. Some keen chaps arrive before it and leave after it, but it doesn’t really do them much good. Occasionally, if I’ve been out at a thrash and got hairy pissers I don’t get in till about half eleven. That is a bit idle, but you know it’s astonishing the business you can do indirectly by being seen at the right places, like deb. dances and so on.”

“You don’t understand these guys. In our world, somebody who gets 1 million pounds just wants to make 2 million pounds. These are people who make money, and spend it. If he spends money on parties and racehorses, I say, ‘fine’ because he will want more. I want a guy who lives well, and is hungry.”

If you said the second, you would be wrong, unless you have great confidence in your piranha survival skills. That was Christopher Heath, who put together Barings’ infamous Japanese dealing operation that broke the bank. Among the guys who “lived well and was hungry” that he hired was rogue trader Nick Leeson.

Before the 1986 “Big Bang” the City was atomized, rather like a mediaeval “guild” system. Merchant banks, clearing banks, stockbrokers, jobbers, commodity brokers and discount brokers each performed a different function, and each had its own set of social and intellectual attitudes — the insurance market was completely separate.  Within the financial area, trading was concentrated in jobbers; stockbrokers did not trade, nor did merchant banks, except in the money markets. Thus the archetypal “barrow boy” traders were concentrated in a small part of the City’s ecosystem, though even in that area there were also a number of upper-class types with capital to employ and a taste for short-term action.

While some stockbrokers early on, notably Phillips and Drew, concentrated on research, the broking profession in general was pretty un-cerebral, and contained mainly well connected Drones Club types like the 1967 broker quoted above, with an actual or potential base of retail clients, together with a number of middle class strivers (generally NOT likely to end up as Senior Partner) who dealt with the institutions, or acted as primary liaison with the jobbers on the Stock Exchange floor. Stockbroking as a whole was a notably less lucrative profession than either jobbing or merchant banking.

The trading system for stocks, therefore, was one of “single capacity” similar but not identical to that used on the New York Stock Exchange both then and today. Jobbers made the market and took positions, while brokers acted as salesmen, researchers and order takers. Joint ownership of brokers and jobbers was prohibited.

The system worked beautifully in preventing conflicts of interest, but suffered because jobbers were intrinsically undercapitalized. With top rates of income tax as high as 98 percent until 1979, and with short-term capital gains from 1961 taxed as income (another blow to the city delivered by the ineffable Harold Macmillan) it was impossible for new jobbers to build up capital. As share investment became concentrated increasingly in the institutions (another result of post-1939 tax rates) the result was an epidemic of mergers and disappearances by jobbing firms, the number of which contracted from 237 in 1947 to only 14 by 1979, and the concentration of jobbing capacity in as few as four top tier names. As a leading jobber complained to the Stock Exchange Council as early as 1962, the jobbing system was like “a 1926 vintage Rolls Royce, supreme in outward appearance, with no wheels.”

With the arrival of sensible tax rates in 1979, and still more after the reduction of the top rate of income tax to 40 percent in 1988, this problem would in due course have solved itself, with new firms of jobbers springing up in the entrepreneurial 1980s and 1990s, just as there arose rapidly a network of “local” traders on the new London International Financial Futures Exchange, formed in 1982. Instead, however, the dead hand of government entered the picture, abetted by a feeble Bank of England Governor, Gordon Richardson.

In 1976, the Labor government extended the Restrictive Practices Act to the service sector, giving the Office of Fair Trading jurisdiction over the city. The Stock Exchange rulebook was submitted to the OFT in 1977, which in turn submitted it to the Restrictive Practices Court in November 1979, after the Thatcher government had come to office. The court’s wheels ground slowly, but by 1982 it was clear that it objected to single capacity and to fixed brokerage commissions (fixed commissions had been abolished in New York in 1975, resulting in a bloodbath). The court case was due to come to trial in January 1984.

At this point, with the Stock Exchange threatened both legislatively and by the advent of an increasingly strong group of U.S., Japanese and European banks and brokers, Richardson took control and decided on a policy of preemptive surrender. The bank produced a plan under which fixed commissions and single capacity would both be swept away, and the Stock Exchange floor opened up to be run in parallel with a screen-based Nasdaq-type trading system. The one existing system which was retained was “self-regulation”; theoretically, at least there was to be no equivalent of the U.S. Securities and Exchange Commission. The re-elected Thatcher government, glad to be doing something that removed a potentially embarrassing legal battle and appeared to have the backing of the city, abandoned the court case and brought in what became the Financial Services Act of 1986.

Restrictions on cross ownership between jobbers, brokers and merchant banks were also abolished, which resulted in an orgy of takeovers, as stockbroking partners in particular, appalled by the prospect of a deregulated city, seized the chance to sell out and retire. The new regime itself was instituted by “Big Bang” on Oct. 27, 1986, which swept away both single capacity and fixed commissions.

The results were in many respects a disaster. The new regulatory regime proved both a bureaucratic nightmare and fairly ineffective at catching malfeasance; it was replaced in 1996 by the Financial Services Authority, effectively an SEC. The stock exchange trading floor was abandoned within three months of the change, because electronic trading appeared to be cheaper. It turned out that electronic trading was far more suited to relatively low-skilled operatives within huge financial houses with good risk controls, so both the stockbrokers and the jobbers that had been bought out, all the big ones except Cazenoves, were rapidly swallowed up by the behemoths that had bought them. By the middle 1990’s, the London financial market was dominated by U.S., German, French and the occasional Japanese highly capitalized universal banks, with the British presence notable by its absence.

There is a considerable school of thought, including Kynaston, which says that this was all for the best. The opening up of trading in the 1980’s to those with non-elite backgrounds, and the increasing dominance of financial institutions by their trading floors, were both a desirable democratization and an inevitable consequence of technological change. Kynaston regrets only the passing of the brief 1980s age of the “barrow boys,” the true East End uneducated traders, in favor of the smooth upper-middle-class MBA’s, similar to those that have since the 1970s dominated trading floors in the U.S. investment banks.

The falsehood of this thesis was demonstrated in 2000, with the almost successful bid for the Stock Exchange by the Deutsche Bourse, and the relegation of the London International Financial Futures Exchange to second or even third place in Europe. After all, since Britain is a wealthy country, it is indeed strange that none of the major London investment houses is now British-owned. Maybe indeed the city, far from having cemented its dominance in Europe and its competitiveness worldwide is due to enter a period of decline. After all, there is no longer a distinctive City of London financial culture, no longer an especially flexible regulatory system, and no longer a huge pool of uniquely capable British financiers, either on the corporate finance or the trading sides of the business.

In the insurance market, the story was similar but in the end even less successful. Traditionally, Lloyd’s insurance market operated a unique system, under which wealthy retail investors — “Names” — guaranteed but did not invest money in underwriting syndicates. These syndicates in turn underwrote insurance risks, which were placed among them by brokers. Insurance claims were paid by the underwriting syndicates, which had the right to call on the Names up to their entire wealth in the event that syndicate cash reserves were insufficient. The system worked well, provided there were enough Names and the losses suffered by any one underwriting syndicate were not catastrophic.

Because of Lloyd’s unique tax status, the high levels of income tax prevailing before 1979 were actually an advantage in attracting Names, since this was one area in which the wealthy could achieve attractive after-tax returns — indeed, Lloyds’ tax status gave it a certain advantage over foreign competition through its lower cost of capital. The management of Lloyds, like that of the Stock Exchange in the 1960’s, was very conservative, but by the end of that decade it had become aware that Lloyds was losing out to newly aggressive U.S. and continental European competitors. Its solution, in 1968, was to call in ex-Bank of England Gov. Lord Cromer to head an enquiry.

Cromer recommended that the minimum wealth to become a Name should be reduced, and that a system of mini-Names, with lesser participation, should be introduced. More important, he proposed that companies should be eligible to become members of syndicates, warned against conflicts of interest between brokers and Names, and warned against the arrogant, potentially corrupt way in which Names were treated by the managers of underwriting syndicates.

Lloyd’s management was horrified; the Cromer report was suppressed, not only from the public but from the Names themselves, and only the reduction in minimum Name wealth was carried out. This was a pity. Lloyds eventually carried out all the reforms that Cromer recommended, but twenty years later, after an enormous series of scandals and the bankruptcy of many of the Names through unexpected losses, abetted by wildly irresponsible underwriting activities.

The worst of Lloyds’ losses were incurred in the United States, a country in which insurance fraud or near fraud is something of a national sport.  In cases such as asbestos, in which liabilities arose decades after the policies had been written, the existence of wealthy foreign insurance underwriters proved an irresistible temptation, time after time, to rural U.S. judges and juries.  Consequently, Lloyd’s Names, instead of having an attractive, reasonably secure and tax-efficient investment, suffered in some cases enormous losses, and were forced into situations of extreme personal hardship. Locking the stable door after the horse had bolted, Lloyds instituted a series of reforms from the mid-1980s, allowing the entry of corporate capital in 1993.

It is however unlikely that Lloyd’s will survive much longer as a serious competitor in international insurance. Its market share has dropped consistently since 1980, and is now quite small. Its cost advantage over conventional insurance companies has disappeared, or even been reversed, and it continues to suffer substantial losses in the United States. Not only is it a sitting target for the ever wealthier and more powerful trial lawyers, it is also victimized by such tactics as World Trade Center owner Larry Silverman’s attempt to claim twice on the same insurance policy after Sept. 11, on the grounds that two, not one, airplanes had hit the complex. Yet again, Lloyd’s paid up; the U.S. balance of payments for September 2001 was swollen by $11 billion of foreign insurance receipts, much of it from Lloyds’. Short of “redlining” the United States altogether and concentrating on continental Europe and Asia, there would appear to be no long-term solution to Lloyds’ problems.

The decline of the city’s financial businesses, on the other hand, could have been avoided had the Thatcher government, instead of assuming that Richardson spoke for the city as a whole, chosen to consult a range of merchant bankers, brokers and jobbers, or better still Cromer, who was still very much around in 1983. Cromer, who had both stronger free market principles and a greater depth of understanding than Richardson, would have told the government a few hard facts and, one hopes, persuaded them to cease meddling, legislatively or judicially, in the delicate mechanism of the City of London.

Dual capacity did not need to be abolished; it remains in the New York Stock Exchange to this day. The Stock Exchange trading floor should also, as in the NYSE, have been retained — there is considerable information provided to an experienced broker or trader from the noise and pattern of floor trading. Thus keeping the trading floor would have “tilted the playing field” toward experienced London brokers and jobbers, and away from “barrow boys” and foreigners. Even fixed Stock Exchange commissions could have been retained, although the rise of institutional investors meant that severe reductions were necessary, particularly in the area of “gilts” (fixed income securities). As for regulation, that was perfectly satisfactorily carried out by the Bank of England, aided by the voluntary industry bodies of the Issuing Houses Association, the Accepting Houses Committee and the Takeover Panel.

Of course, even more devastating to London’s financial capability than the loss of independent British stockbroking and jobbing was the loss of the merchant banks. That, too, was caused by ineptitude, particularly but not exclusively in the early 1980s; it is discussed in part III through V.

Review: Part III — Merchant Bank revival

This third part covers the revival of the London merchant banks after World War II, until they had regained their position at the end of the 1960s as the world’s most important financial institutions.

There is no question that, from 1914 until the late 1950s, the London merchant banks were a very sleepy group, with a work pattern so lacking in stress that it was possible for the first Lord Bicester, the chairman of Morgan Grenfell, to remain in harness full time (so to speak!) until his death at the age of 88 (and then to be succeeded by his son). Merchant bankers were the elite of the city, socially, financially and (in moderation) intellectually.  They were defined by membership of two clubs, the Issuing Houses Association, formed in 1946 to ensure quality control of new issues of debt and shares, and the Accepting Houses Committee.

The Accepting Houses Committee was the core of the London merchant banking system. Members of the Accepting Houses Committee, of whom there were 16 in 1980, had a unique privilege; their bills could be discounted by the Bank of England at its “finest rate.”  Effectively therefore, at least for trade finance, members of the Accepting Houses Committee had a Bank of England guarantee.  The privilege was highly valuable, if only in terms of the cost of the banks’ funding, and was granted or withdrawn according to the Bank of England’s desires. Sigmund Warburg, 10 years after his bank was already a major force in the London market, was compelled in 1957 to buy an Accepting House, Seligman Brothers, to gain entry to the inner circle. Conversely Keyser Ullmann, which became among the best capitalized of the merchant banks in 1972, when it sold a property portfolio, was not allowed into the Accepting Houses Committee — “They do not like some of your colleagues,” Bank of England Gov. Leslie O’Brien told Keyser Ullmann Chairman Edward du Cann. The bill discounting privilege was withdrawn in 1981, with only minor public notice, as many of the merchant banks felt by then they had grown too large for it to be useful; the withdrawal was a key event in the merchant banks’ decline.

Apart from acceptances, the key activity of the merchant banks after World War II was the new issue business. This had been dominated by stockbrokers before 1939, but the new disclosure requirements of the 1948 Companies Act made documentation more complex, so that even in the decade to 1956, more than 65 percent of new issue business was carried out by members of the Accepting Houses Committee. From the mid-1950s, takeover bids assumed an increasing importance also, with Warburgs’ successful 1958-59 assault on British Aluminium, the first contested takeover bid on either side of the Atlantic, playing an important catalytic role in their growth.

Kynaston fails to understand why merchant banks were needed in the takeover business, describing their dominance of the market as “in many ways a confidence trick — if one accepts that in a takeover bid a lawyer may be needed for transactional reasons, an accountant to check the figures and a broker to advise on the market, but that a merchant banker is no more than a highly paid orchestrator of these activities.” By the same reasoning, if one has a bricklayer, a carpenter and a plumber, there is presumably no need of an architect to build a house, but in practice the services of architects remain in demand.

In reality the new issue business, the takeover advisory business, and the more complex end of the banking business were all areas falling naturally into the London merchant banks’ business niche.  While certainly in the 1950s the merchant banks’ social status was more notable than either their profitability or their intellectual creativity, this was the result of the long City quiescence after 1939, with many traditional City activities, particularly those involving international finance, being outright prohibited by some item or other of Socialist legislation.

Even during this period, there were exceptions.  One was Sigmund Warburg, son of the German private banking dynasty, who founded Warburgs in 1945 and built it up into a major force by the late 1950s.  Another was Kenneth Keith, who put together Hill Samuel from 1945-65; his story is examined further in Part IV. However, by the late 1950s, with the revival of the takeover market, the reopening of the foreign exchange market, and the beginnings of the eurodollar deposit market, merchant banking had once again become an attractive avenue for first-class Oxbridge graduates. From 1960 or so the merchant banks, though not the stockbrokers, jobbers or insurance brokers, began to get them.

The real breakthrough in taking the merchant banks back toward their historic pre-1914 position was the inception of the Eurobond market in 1963.  While encouraged by Lord Cromer, then governor of the Bank of England, the merchant banks were severely handicapped in this area because they had no placing power. Domestic U.K. investors were unable to buy Eurobonds except by paying a premium to buy dollars, one quarter of which had to be surrendered when they sold the investment. Nevertheless, the continental European banks were sleepy enough that the merchant banks were able in the early years to carry off the lion’s share of the new issue mandates, with only the U.S. investment banks (also prevented from selling domestically because the securities were not registered with the SEC) as significant competition. From this point onward, the merchant banks were back in the business of international finance.

One of the merchant banks’ key capabilities, of which Kynaston makes too little, was innovation.  At least until 1980 the City of London, and the merchant banks within the City of London, were the principal innovators in the international financial arena, well ahead of their contemporaries in New York.

Wall Street had been badly damaged by the 1929 crash, and in particular by the Glass Steagall Act, which had walled off the commercial banks into being almost pure deposit taking institutions, little more innovative than the London clearing bank oligopoly, while creating investment banks that were in general strongly driven by the drive for short term profits. The gulf between the two was evidenced by no less a figure than Walter Wriston, chief executive of Citibank from 1967-84, who according to his biographer described investment bankers as people “who would sell their mothers for a sixty-fourth.”  Some of the investment banks, such as Morgan Stanley and Kuhn Loeb, were culturally similar to London merchant banks but the majority, driven by brokerage and trading revenue streams, were naturally far closer to stockbrokers, albeit far more aggressive than the London variety. International business, when competing with the cornucopia of fee income that could be achieved in the U.S. market, was always low man on the investment banks’ totem pole.

Businesses that were to be important internationally, and appear to have been originated by London merchant banks, include but are not limited to the following:

* Syndicated loans.  Citibank appears to have done the first U.S. syndicated loan, for United Parcel Service in 1954.  Schroders merchant bank was doing them in the London market, in a “clubbish, undemanding” (Kynaston’s words) way at least two years earlier: “It took less than five minutes and to get there you’d walked half-way across the City. Bowler hats and all.”

* Eurodollar deposits. Traded in London, without the involvement of the U.S. banks, from 1957-58.

* Contested takeovers. The British Aluminium takeover, contested between Tube Investments and Alcoa, was won by Warburgs in 1959. The first such contest in the U.S. was the International Nickel deal done by Morgan Stanley in 1974.

* Eurobonds. Pioneered by several City merchant banks in 1963.

* Investment analysis. Phillips and Drew, the London stockbrokers, set up the first stand-alone team of investment analysts providing quantitative investment analysis reports for institutions, about 1956.  The product was pioneered in the United States by the investment bank Donaldson, Lufkin and Jenrette, from 1960.

* Currency swaps.  Arose as parallel loans, to get around the “dollar premium” restrictions for U.K. institutions investing abroad.  First transaction believed to have been done by Warburgs in 1969.

* Interest rate swaps.  Invented simultaneously by Warburgs and Citicorp (London) in 1981 — but the Citicorp banker involved, Denys Firth, was an English public school product who would have been a merchant banker ten years earlier.

* Inflation linked bonds.  First issue by the U.K. Treasury, with merchant bank advice, in 1980.

As their international business grew, it began to become apparent to a number of merchant banks that they might need to grow themselves to retain a competitive position in the market.

On the other hand Cromer, as always a very sound strategic judge, minuted in 1965 “Apart from prestige and standing which is vital to all of them, it is initiative, ingenuity and the readiness to adapt themselves to contemporary situations which provide a common denominator.  It is certainly not a question of size.”

Cromer put his finger precisely on the nub of the matter; the merchant banks’ strengths were client service and innovation, in both of which areas they had by the late 1960s recovered much of their pre-1914 pre-eminence.  Once a financial business became a commodity, with size and risk appetite the key factors for success, and client service and innovation unimportant, then the merchant banks were too small to compete.

These were the central dilemmas facing the merchant banks in 1970, of how they could regain their traditional international capabilities and client bases, and of what size they should be to succeed in the international market. They could innovate in the Eurobond market, and carry out international equity financing while remaining fairly small, and advisory work, on acquisitions or other matters and investment management business did not in themselves require capital at all, but if the size of bond issues grew, and underwriting risks became more concentrated, they would very quickly outgrow their capital base, which was minuscule compared to that of their Continental competitors, or to their U.S. commercial banking competitors such as Citibank.

In Part IV, I focus on Hill Samuel, and how it attempted after 1970 to solve this problem — in the end without success. In Part V I focus on the transition by the leading London merchant banks to a trading culture, and how that too ended in failure. It should not however be imagined that failure was inevitable; as of 1970, there were many possible avenues that could have been tried.

Review: Part IV – Retreat: Hill Samuel

This part looks at merchant banking in the 1970’s, and concentrates in particular on the struggle for a viable business niche by Hill Samuel, in 1970 one of the largest merchant banks, and one with particularly creative top management.

As mentioned in Part III, the central questions facing the merchant banks in 1970 were those of how to regain their pre-1914 international capabilities and client bases, and of what size they should be to succeed in the international financial market. They could innovate in the Eurobond market, and carry out international equity financing while remaining fairly small, and advisory work, on acquisitions or other matters, did not in itself require capital at all, but if the size of bond issues grew, and underwriting risks became more concentrated, they would very quickly outgrow their capital base, which was minuscule compared to that of their Continental competitors, or to their U.S. commercial banking competitors such as Citibank. This was, in particular, the dilemma facing Kenneth Keith at Hill Samuel (for which, to insert a personal note, I worked from 1973-79) as the 1970’s opened.

Kenneth Keith, after a successful war as a Welsh Guards officer, joined the investment trust (closed end mutual fund) Philip Hill in 1946, bought a small merchant bank, Higginsons in 1950, joined the Accepting Houses Committee (the core “club” of merchant banks, whose bills were discounted at “best rates” by the Bank of England) in 1959 and proceeded by further acquisitions of Erlangers in 1960 and M. Samuel in 1965 to build Hill Samuel, which by the early 1970’s had become one of the City’s largest and most successful merchant banks.

Keith came more or less from a traditional merchant banking background, but was far more aggressive and entrepreneurial than most traditional merchant bankers. Indeed, he was something of a rogue; on the only occasion I spent time with him, at a dinner in the late 1970’s after trading shares on insider information had become an ethical issue (though not formally illegal until 1980), he remarked “Now that insider trading’s forbidden I don’t know how you YOUNG chaps make any money at all.” (You should imagine all remarks made by top merchant bankers before 1980 to have been emitted in a particularly extreme port-sodden version of the old-fashioned English upper class accent.) It has to be said that, with inflation having decimated salaries in real terms and mid-1970’s tax levels having chewed away at what was left, we didn’t in fact make much money.

Hill Samuel differed from other merchant banks in not having a founding family at the top — Keith had forced out the Samuels from active involvement. It achieved the necessary “prestige and standing” in Lord Cromer’s term by employing outsiders such as (since 1955) Sir John Colville, Churchill’s former Private Secretary, who provided the appropriate merchant bank atmosphere at client lunches by his normal conversational opening “When Winston and I were at Casablanca … ”

The bank had been remarkably successful in U.K. corporate finance, having in 1967-68 put together General Electric Company, the largest merger in the United Kingdom then or for 20 years afterwards, and having the largest number of U.K. corporate clients in Crawfords Directory of City Connections of any merchant bank.

Internationally, it had enjoyed considerable success in the early Eurobond and international equities market, although the collapse of Bernard Cornfeld’s Investors Overseas Services offshore mutual fund empire was to prove a blow. Nevertheless, as late as 1972 the bank carried out within six weeks the two largest Eurobond issues in history, of $60 million and $70 million, both for Shell. The bank however remained largely domestic in focus — as my first boss, Hamish Lamont, once said to his Belgian superior “The trouble with doing international business is you have to deal with all these f***ing foreigners!”

If Hill Samuel was to expand internationally, it needed both more capital and a base of “tied” clients, preferably among both borrowers and investors, of higher quality than Cornfeld and his ilk.

Keith’s first attempted solution to the merchant banks’ twin dilemmas focused purely on capital, by trying in 1970 to merge with MEPC Ltd., a large real estate company. This would have made the international dimension of the problem if anything worse, but would have quadrupled Hill Samuel’s book equity value. Keith was however foiled in this attempt by a rival bid, orchestrated by his merchant bank competitors.

Keith next attempted, three years later, to merge with Slater Walker PLC, an international leveraged buyout (10 years before that term was used), banking and fund management operation controlled by entrepreneur Jim Slater. This would have been a much better alliance, since Slater’s team of tough whiz-kids would have shaken up the remnants of Hill Samuel’s merchant banking culture to good effect.

Since Slater had a large Asian operation, it would also have added to the group’s international clout in the fastest growing of what were not yet known as “emerging markets.”  Even more interestingly, it would have focused the group on investment management (Slater had a big and successful mutual fund operation) and on private equity investment, and away from the commoditized trading operations that were shortly to seduce the London merchant banking community to its doom.

In the event, the deal fell apart on “personality differences.” Keith and Slater got on fine (Slater was, after all, 19 years younger, so could expect to inherit the joint group) but Slater was loathed by Keith’s deputy Robert Clark, a cautious, indecisive and domestically oriented former lawyer. Later, Hill Samuel rationalized the failure by pretending they had seen the flaws in Slater’s loan and asset portfolio.

As it turned out, the financial crisis of 1973-75, (which Slater had already foreseen at the time of the merger, making a “dash for cash”) hit both organizations hard. Hill Samuel lost 21 million pounds (then $56 million, more than a third of its capital) when the German Bankhaus I.D. Herstatt closed in 1974 halfway through a foreign exchange “spot” transaction and Herstatt’s U.S. bank Chase Manhattan tried to keep the money — Hill Samuel won in court, and recovered almost all its loss, but it took two years and left the bank weakened at a very difficult time.

Slater Walker, having gone liquid, survived 1974 nicely, but ran into trouble the following year when its Asian management team was arrested in Singapore; the company was forced into orderly liquidation by the Bank of England in August 1975, though some of the businesses survived. While the combined group would probably have survived — just — it would have been in no position, in the horrible years after 1973, to engage in significant international expansion.

Keith gave up full time involvement in Hill Samuel after the Slater Walker failure, to become Chairman of the state-owned aircraft engine company Rolls Royce (which he revived very successfully, ending as Lord Keith of Castleacre as reward for his efforts.) The next Hill Samuel “strategic study” of 1975-76, in which I was involved, was led by Clark.

That study concluded that Hill Samuel should form an alliance of cross shareholdings with a continental bank with Eurobond placing power, such as the Belgian Kredietbank, and a U.S. investment bank such as Salomon Brothers. Laughably unequal as the latter arrangement sounds now, it was in fact not implausible in 1975, at which point (based on 1973-4 figures) Hill Samuel’s capital was still significantly larger than Salomon’s, and the latter had yet to open a London office.

In fact it was already too late. Hill Samuel had been hard hit by Herstatt, by high U.K. inflation and a depreciating currency, by penal levels of U.K. personal taxation in the mid 1970’s, and by a moribund U.K. issue and takeover market. In real terms, its balance sheet shrank by 46 percent between 1973 and 1977 and its profits by an equivalent amount.

Clark, who had kept the 1975-76 studies carefully away from Keith, still nominally the Chairman, lest they prove subversive, obtained in 1978 two new minor shareholders, an Arab consortium and a Texas bank. Neither new shareholder was a significant help in terms of capital or any help whatever in terms of business — the Arab consortium had to be bailed out within two years by Hill Samuel itself, while the Texas bank went bankrupt in 1986. From 1980, Hill Samuel was essentially absent from the international markets. Keith attempted in that year to sell the bank to the U.S. investment bank Merrill Lynch, but Clark blocked him and he resigned from the Hill Samuel chairmanship.

Clark attempted in 1987 to sell Hill Samuel to Union Bank of Switzerland (the No. 2 solution in the 1975 study) but by now it was far too late — even this attempt failed, and the bank, having been put “in play” was taken over, right at the top of the 1987 bull market, by the dozy entirely domestic retail savings bank TSB, which proceeded to lose 240 million pounds ($400 million) in Hill Samuel alone the following year by going all-out in lending to fringe real estate operations.

Hill Samuel was closed in 1994, after TSB had been sold to the retail commercial bank Lloyds Bank PLC. About all that can be said for Clark is that, by selling at the top of the market, he got a magnificent price (five times net asset value) for Hill Samuel shareholders — but that had always been right at the bottom of his list of objectives.

Review: Part V — Merchant bank recessional, 1979-

This fifth part covers the attempt of the London merchant banks after the Thatcher government’s arrival in 1979 to maintain their position of importance in the world of international finance, and their ultimate failure to do so.

As mentioned in Part III, the central dilemmas facing the merchant banks in 1970 were how to regain their pre-1914 international capabilities and client bases, and what size they should be to succeed in the international financial market. Hill Samuel was the principal innovator attempting to solve these dilemmas in the early 1970’s;  its failure, and the difficulties it ran into from 1974 on, caused it to fall back in the pack of competing merchant banks.

By 1979, when Margaret Thatcher came to power, the leading London merchant bank was unquestionably Warburgs, which was indeed the only merchant bank to have retained a prominent position in the Eurobond issue market, and had in addition built up a substantial and increasingly profitable business in the new field of currency swaps.

Of the other merchant banks, Morgan Grenfell had the greatest strengths in domestic corporate finance, and had consciously modeled itself on Kenneth Keith’s aggression and competitiveness though its ex-Hill Samuel head of corporate finance, Christopher Reeves.  Reeves, however, got it wrong, describing Morgan Grenfell’s culture as being one of “public school bully boys.” This unattractive simile ignored the fact that “bully boys” in traditional English public schools tended to be the students of low intelligence, largely uneducable, and destined to sink sharply in the social scale once parental financial support was cut off.  As the Guinness scandal of 1986 was to show, the simile was altogether too apt for Morgan Grenfell to achieve long term success.

Kleinwort Benson, primarily through high quality commercial banking and Schroder Wagg, through bond issuance and fund management, were the other houses in the top tier in 1980, while Rothschilds, which had exited the Eurobond market in 1974, Hambros, which was concentrated in Scandinavia and had lost money in shipping and Hill Samuel were a step behind.  Still seeking for a role was Barings, which had achieved the magnificent coup in 1974 of having its man Leonard Ingrams appointed chief advisor to the newly powerful Saudi Arabian Monetary Agency.  However, it had lost its leader and principal strategist when Lord Cromer, the former Bank of England Governor, went to Washington as ambassador in 1971;  on his return three years later he was very definitely not allowed to return to Barings by his cousin Sir John Baring, then the bank’s chairman.

Cromer’s principal long term legacy to Barings was the creation of the Baring Foundation, to hold the family’s shares (he was rightly concerned that the bank’s capital base could be decimated by estate tax levies.)  This resulted in share dividends no longer being the family’s principal source of income and bonuses, based on short term performance, becoming of great importance for the Baring family members running the bank.  The change was to be highly significant in the years to come.

Thatcherism did a number of things for the City.  It finally removed exchange controls, allowing British investors to take an interest in the Eurobond market, a substantial Eurosterling bond market to grow up, and international equity placings to be done regularly from a London base.  It removed the punitive top rates of tax, which would have allowed the stock exchange jobbers to revive, had they been given time or the environment in which to do so. It brought the new business of privatization, which was to prove enormously lucrative both in the U.K. and worldwide.  Most important, it brought a culture of deregulation, whereby British houses could at last compete on equal terms with foreign banks.  After the dark period of the 1970’s, when inflation had eroded the merchant banks’ capital bases and foreign banks had gathered strength, it was however all rather too late.

The story of the early 1980’s, and the revolution surrounding “Big Bang” was one of the merchant banks missing opportunities, not because they did not realize the possibilities involved, but because they were simply not big enough to compete on equal terms with foreigners, or even with the clearing banks.  Foreign exchange, syndicated loans and Eurobond issues had all become commoditized businesses requiring substantial devotions of capital and appetite for risk; in an ideal world, the merchant banks would have abandoned these businesses to their larger competitors and would have focused instead on areas where their traditional strengths of client service and innovation could still give them the advantage.

They would have been considerably helped in this endeavor if they could have kept the Accepting Houses Committee privilege of discounting bills “at best rates” at the bank of England.  This gave them an effective Bank of England guarantee, and would have enabled them to continue in for example the derivatives business without the credit worries that Enron and its competitors were to incur. Indeed, there can be no doubt that, had energy derivatives come into public view in the 1970’s instead of the 1990’s, they would have been developed in London by the merchant banks, which would have benefited from the implicit Bank of England guarantee and thus, even if they had bet wrong in the markets, there would have been no liquidity scare and consequent collapse.

However, after 1981 the implicit Bank of England guarantee of the merchant banks was not there (the Accepting Houses Committee itself was disbanded in 1988), and after the Barings collapse of 1995 it would have been clear to even the doziest Californian counterparty that the guarantee was not there. Big Bang may have increased the remuneration of many of London’s bankers; it did nothing whatever for the innovative capabilities of the City.

Instead, with the notable exception of Rothschilds and Hambros, the merchant banks mostly tried to grow. To some extent, with the appalling increase in bureaucracy produced by the 1986 Financial Services Act, growth in staff was inevitable, if only in compliance officers, trading back office and other undesirables.

In particular, in the early 1980’s the merchant banks entered into the bidding war for stockbrokers and jobbers that opened up with the decision in 1983 to abolish “single capacity” and fixed brokerage commissions.  Having paid large, normally excessive amounts of money for brokers and jobbers, many of the best partners of which took the opportunity to retire, the merchant banks found themselves with an income stream that was far more focused on trading and brokerage income, inevitably short term in nature, than had traditionally been the case.  The cultural adaptation to this varied from bank to bank, but it was always at best difficult.

In the case of Warburgs, the bank had already built a substantial position in the Eurobond secondary market before 1979, and Sigmund Warburg himself was highly opportunistic. Hence the bank’s purchase of Rowe and Pitman and Ackroyd and Smithers, among the strongest of brokers and jobbers respectively, caused relatively little cultural clash or change in methodology.  Moreover Warburg’s asset management arm, Mercury Asset Management, became the second largest money management company in the U.K. and was in general hugely profitable. However, after Sigmund Warburg died in 1982, Warburgs had no leadership with a strong commitment to independence.  A poorly timed and very costly expansion of its U.S. operation in 1992, and an expansion of fixed interest trading in early 1994, just before dollar interest rates moved sharply upwards, endangered the bank’s profitability (though not even denting its survival prospects), and in a bonus driven era, that was enough.  A merger with Morgan Stanley proved abortive, and in May 1995 the bank was bought by Swiss Bank Corporation.  The strongest of the London merchant banks had lost its independence, though at least in this case the name (now UBS Warburg) and many of the people still survive seven years later.

Morgan Grenfell, which in the mid 1980’s looked the strongest of the corporate finance houses, had been forced to buy a second tier broker and jobber because of lack of capital.  In any case, in 1986 its “public school bully boy” culture ran into serious trouble at the time of the Guinness takeover when, as one would expect from people with such a self-image, aggression took the place of intelligence, the law was repeatedly broken and jail sentences resulted.  In spite of recruiting a top quality outside Chief Executive in John Craven, Morgan Grenfell sold out four years later to Deutsche Bank, a move that was not even well timed.  The Morgan Grenfell name and culture soon disappeared, but in any case the Morgan Grenfell of Lord Bicester was long dead.

Kleinwort Benson, which bought Grieveson Grant, a high quality stockbroker, lasted longer than most houses, and did very well out of privatization business, but in 1995, after the Warburgs sale and the Barings fiasco, the bank decided that capital market business in particular was simply too low-margin to be attractive; accordingly it sold out to Dresdner Bank, albeit for quite an attractive price.  Again, absorption rather than independence was to be the result.

Schroder Wagg pursued a different route; it decided to set up its own broking firm, which was probably sensible.  With Bruno Schroder (Harvard MBA Class of 1960) guiding it, the bank seemed destined to remain a bastion of independence, and indeed it remained profitable throughout the 1990’s.  Regrettably, in 2000 the lure of the money proved too great (also, like Slater Walker Chairman Jim Slater in 1973, Bruno Schroder may have seen trouble coming) and the investment banking business was sold to Citigroup for $1.8 billion.  Schroders Investment Management, however, remains independent and under family control.

The catastrophe, of course, was Barings.  Having resisted the return of Cromer in 1974, Barings was left with top management with no strategic sense of where they were going, and little ability to master the more arcane techniques of modern finance.  Leonard Ingrams, their brightest young star, when he returned from Saudi Arabia in 1979, was forced out of corporate finance by Andrew Tuckey.  When Big Bang came, Barings bought the broker Hendersons, and in particular its Japanese trading operation headed by Christopher Heath, whose legendary financial aggression I noted in Part II.  Heath built up a huge business in Japanese equity warrants, hiring “barrow boy” traders with little education, who he felt were aggressive enough for his needs and demands.

Of all the post 1986 cultural clashes in the City, Barings was the worst.  Unlike more “middle class” houses like Hill Samuel, it had not hired many non-bluebloods in the 1960’s and 1970’s, and indeed there was a sense that the Baring family themselves did not really distinguish between a middle class MBA Oxbridge graduate and a barrow boy.  Heath, who had some control over the people he’d hired, was forced out by Tuckey in 1993 (having for two years in succession gained notoriety as the “highest paid man in England”) — in any case, by that time the bloom was off the rose in Japan.  It was inevitable then that one or more of the traders, finding the easy money gone, would result to fraud and subterfuge to keep the bonuses coming, and that top management, themselves reliant on annual bonuses rather than steady partnership income, would not ask the questions they should have.  The eventual culprit was Nick Leeson; if he had never existed it would have been someone else.

When the Barings crisis was presented to the Bank of England, in February 1995, it was naturally supposed that a bailout would be arranged.  In the 1970’s, tens of fly-by-night fringe banking operations had been bailed out by the clearing banks, under Bank of England instructions.  In the 1980’s Johnson Matthey, a long-established name in the gold market but no Barings, was also bailed out.  However, in this case the money required was larger, some $800 million, and the politicians were against it.  Kenneth Clarke, Chancellor of the Exchequer, suddenly discovered free market scruples and the dangers of “moral hazard” (for probably the only time in a long and undistinguished ministerial career) and Barings was history. In fact, of course, this was not some U.S. regional bank, so there was no possibility of “moral hazard.” There were very few equivalents of Barings in terms of “name” and none at all in terms of top management ineptitude.

Robert Fleming & Co., not an Accepting House but a major fund manager, was also sold in 2000 for the magnificent sum of $6 billion — again, as with Schroder Wagg, the Fleming family felt that $1 billion or so in the hand was worth a potentially long and difficult recession in the bush.

At this stage, therefore, of the larger 1980 Accepting Houses, there remain Lazards, close to merger with its New York and Paris cousins, Hambros, split in two in the late 1980s and now a relic, and Rothschilds. One can hope for their survival, and more interestingly, ponder on the possible shape of the City in the years ahead; this I do in the final Part VI.

Review: Part VI — The future City

This part looks at the present setup in the City of London, discusses why it is structurally unstable, and suggests alternative views of what the City may look like circa 2020.

Currently, the City is dominated by very large, wholly trading oriented, foreign owned financial institutions, which offer a full-line service to clients, pay their staff extraordinary salaries (when annual bonuses are included), have high staff turnover and very early retirement.  Strategic management of the City’s financial institutions is carried out primarily in Frankfurt, Paris, New York or Tokyo. Their staff are still mostly British, and still at the professional level primarily Oxbridge, but are far more financially aggressive than their predecessors, and expect to make enough money to retire, or at worst open a restaurant, before the age of 40.

This is a highly unstable situation for a number of reasons. Paying extraordinarily high salaries and retiring people at 40 is extremely cost-inefficient, and should lead to an influx of lower-cost competition. Having management geographically and culturally separate from operations is expensive, inefficient and dangerous — in the long run either operations will have to leave London, or top management will move there.

Most important, trading-dependent income is extraordinarily cyclical. The growth of trading operations in the last 20 years has been phenomenal, but is far more likely to reflect an 18-year bull market than a real economic equilibrium in which financial services truly represent an ever-increasing part of the world economy.  Structurally, trading operations almost always carry a “long” position, because it’s at least moderately difficult, expensive and dangerous to sell before you buy. Hence, they almost always make money when the market goes up; indeed, a properly managed risk management system would discover for most trading operations, over a lengthy period, that they would do better by firing all the expensive traders, selling the expensive electronic equipment, and investing the trading capital directly in the item that had been traded. Traders themselves, of course, make an extremely good living out of not allowing their top management to think too closely about this.

As an alternative to replacing traders with empty space, you can also replace them with technology. Traditional floor-based markets, like the New York Stock Exchange or the London Stock Exchange before 1986, by their activity emit a huge quantity of non-verbal information which a skilled and experienced trader can use to make money. You don’t need to be an intellectual giant to take advantage of this, but you do need to be a skilled trader with many years of experience in the market concerned through both bull and bear cycles. Screen-based markets appear of course to be much cheaper — as of 1986, it was certainly cheaper to have the trader input his trade directly into the system rather than scribbling bits of paper on a trading floor which had to be input separately. However, screen-based markets, which are in any case no cheaper than traditional ones now we have handheld computer technology, also remove the advantage of skilled, experienced traders. Any but the best traders (as distinct from salesmen, who have customer contacts) in a screen-based system can be replaced by “expert system” software on a $500 PC.

In a bear market, this will happen. Since March 2000, the world’s stock markets have been in a bear cycle, which has been cushioned for many trading rooms by a bull market in dollar bond instruments due to Fed easing. If you believe, as I do, that this bear cycle is likely to continue as the predominant trend (albeit punctuated by secondary reversals) for a number of years, then most trading operations will show consistent losses, year in year out, as the value of their “book” diminishes. The round of layoffs at all major investment banking houses, losses reported Jan. 31 at Deutsche Bank and Credit Suisse First Boston, and the unexpected $750 million loss at Allied Irish Bank’s Allfirst subsidiary, are only the beginning. Over the next several years, it is likely that the trading work force will sharply diminish, remuneration for traders will be savagely cut, very few quality graduates will go into the City, and large international banks will reorient their operations away from trading commoditized products, and toward higher-value-added activities, particularly those related to their core client bases.

By around 2007, therefore, the City will still be dominated by large international banks, but their employment levels will be much smaller, salaries will be much lower, the staff will be ageing in place, and the top end of the London housing market (currently more overblown than it has ever been) will have taken a huge tumble, making 1973-75 and 1989-92 look like a picnic.

At this point, it gets interesting; there are a number of possibilities. However, because of the tendency of economic factors to reinforce one another and pull markets off-center, the compromise possibilities are unlikely to be stable. There are really therefore only two “steady states” that might persist.

At one extreme, if Europe has continued to integrate, Britain has joined the Euro, but at the same time European protectionism and a weak global economy have reduced world trade and the flow of investment between global regions, then it is likely that the financial system will move toward a “Fortress Europa” model. Extra-European business will no longer be a big moneymaker for the London houses, and the International Stock Exchange’s trading volume will be overwhelmingly dominated by European names. Naturally, it will then be seen as more efficient for London to merge with one of the Continental stock exchanges, either the Deutsche Borse or the combine centered in Paris. With screen-based trading, there will be no reason to have more than one exchange for the united EU.

At this point, with no independent stock exchange, the vast majority of its banks owned by foreigners, and only insignificant non-EU business, it is likely that London will simply fade away as a financial center. It is after all dangerous and expensive to run a London investment banking operation at a distance, from Frankfurt, Paris or Munich, and the London operations, after a long bear market, will no longer seem either special or profitable. Much better to centralize investment banking at the head office, employ primarily staff who are completely fluent in your own language and culture, and serve the moderate financial needs of the slow-growing EU companies and the huge financial needs of the EU’s fast-growing government from one center. London can then be left to the pigeons and the tourists.  Maybe the occasional U.S.-owned house will remain, because of language and cultural affinities — but they will find themselves very short of business in the newly protectionist EU.

At the other extreme, if Britain has fought off joining the Euro, distanced itself somewhat from the EU’s protectionist tendencies, and kept its tax levels low enough to be attractive to the highly skilled, then there will still remain a substantial volume of non-EU business done out of London as well as a certain amount of “samizdat” business deals done outside of EU control with continental companies wishing to finance or do business outside the EU’s often slow-moving economic area.

At that point, with the big foreign-owned houses having slimmed down their staffs, they will be found to have cut muscle as well as fat, and much of the more interesting business will be done by “boutiques” generally consisting of a small group of investment bankers, formerly with the big houses, who have used their large bull market bonuses in capitalizing a financial services operation rather than in opening a restaurant.  Naturally, such boutiques will be harassed at every turn by the Financial Services Authority bureaucracy, and if the harassment grows too bad, they will move offshore and we revert to the first model. Nevertheless, a picture in 2007-2010 of a small number of foreign owned “dinosaurs,” at best marginally profitable and a large number of undercapitalized, entrepreneurial “minnows” is at least a plausible one.

It must be emphasized that the minnows will NOT be merchant banks, in the traditional sense of the term. They will be too small, and their lifespan will generally not extend beyond the active careers of their principal partners. Think, for example of Phoenix Securities, formed by John Craven and partners in 1982 to take advantage of the forthcoming “Big Bang” in the City, remarkably successful, in the specialized niche of City mergers, and selling out to Morgan Grenfell for about $20 million in 1989. With no more than 4-5 top partners, and a seven-year lifespan, Phoenix was not a merchant bank and did not hold itself out to be one.

It is nevertheless likely that from time to time several “minnows” will discuss getting together, and attempting to form something more permanent.  They will need a viable long-term business model, they will need a more substantial amount of capital, and they will need what Lord Cromer referred to in 1965 as “prestige and standing.”

In terms of business model, it will be obvious by this time that commoditized trading operations are an intrinsically unprofitable business, certainly not interesting enough to put your own money into, or money from people you care about.  Nevertheless, there will be then as there are today new trading opportunities opening up, whether in the area of exotic derivatives, of emerging market securities, of second-hand private equity stakes or of novel securities designed to solve new risk management problems, which will require specialized trading skill and a high level of intellectual input before they can become commoditized. Designing and trading these new products, like the derivatives markets in the early to mid-1980s, will be highly profitable, and best carried out by small teams of experts.  This time, it is to be hoped that the small teams have the sense to hand the business off to the big banks once margins get thin.

Even more interesting, it will by this time be clear that the New York Stock Exchange, which has retained floor based trading, remains competitive against screen based markets, because the non-verbal information flow and greater sophistication of its traders allow price discovery to be more efficient than in a screen-based market.  Accordingly, it is possible that a group of “minnows” will get together and form a floor-based stock exchange, probably to trade shares from countries whose national stock exchange is small and therefore illiquid.  With modern communications, shares traded can be domiciled in any country in the world (provided the trader understands that country’s business system) and floor trading need be no more expensive than screen trading. The floor-based London Stock Exchange, trading shares from all over the world (as before 1914 but not in the 1960s) would thus have been recreated.

Mergers and acquisitions advice, and fee-earning corporate finance business generally, will of course be a specialty of any such institution, providing it has cracked the “prestige and standing” problem to get such advisory work away from the big houses, which will provide inferior service but may initially be more trusted. This work is very labor-intensive, and much of it is only moderately specialized. Hence it will probably be found attractive for such an institution to sub-contract much of its junior corporate finance work to a pool of highly skilled, English-fluent but cheaper labor — the obvious places for which would be Eastern Europe or India. From personal experience, it is perfectly possible to carry out corporate finance work of the highest quality using Eastern European staff, provided it is properly supervised, and the cost of recruiting even the very best graduates of Eastern European colleges and training them will even in a long bear market be far below that of employing London-based staff. To the extent the new institutions need back office workers they, too, can be subcontracted in this way to low-cost areas; the Internet and cheap international telephone systems are wonderful things.

The final area in which the new institutions can specialize is that of investment management, and particularly private equity investment. It has been pretty conclusively proved over the last two decades that the Efficient Market Hypothesis is wrong, that truly superior investors can indeed beat the market, but that most investment managers might as well be replaced by monkeys picking stocks with a dartboard.  To an even greater extent is this true in the private equity area, and in that of investing in emerging markets, in both of which the “nose” of intelligent experience is of far more use than 100 MBA analysts.  Accordingly, investment management, which does not require capital but does require “prestige and standing” to attract clients, is a natural business for such an institution.

Capital itself will not be a problem for a new “merchant banking” institution.  Not all that much will be needed; the equivalent in today’s money of the capitalization of a typical early-1970’s merchant bank is about $500 million, and it will certainly be possible to start with less than this provided the business mix is selected carefully. (Caspian Securities, started by former Barings executives in 1995 with capital of $250 million, came a cropper in the 1998 emerging markets crisis; it had an entirely sensible focus on emerging markets and a wholly undesirable belief in the efficacy of trading.) The problem is that the capital needs to be combined with operational independence and “prestige and standing” in order to produce an effective business.

Getting money from a large bank, even one of the U.K. clearing banks (supposing there are any such left U.K.-owned by 2007-10) would be a disaster, because of the inevitable interference by the parent. At $250 million to $500 million, it would currently be possible for a group of ex-investment bankers to raise the money from themselves, but by 2007-10, after a long bear market, this may be less easy. An institutional source, such as an insurance company, or better a group of insurance companies, is probably the best option (and could easily be tapped by a management group of the quality necessary to succeed) but would not bring the necessary “prestige and standing.”

There is however one further alternative. The Fleming family made almost $2 billion by selling Robert Fleming & Co. in 2000, and the Schroder family close to $1 billion by selling Schroder Wagg’s investment banking business in the same year (they still control Schroders Investment Management). As merchant bankers, the Fleming and Schroder families should above all be aware of the sublime beauty of selling at the top and buying back at the bottom. Rothschilds, too, is still in business, and the Samuel and Hambro families are not short of cash.

Maybe the new merchant banks, to be founded around 2010, will be owned by the same families as the old merchant banks founded in 1800 or so. The Bank of England, if it really wanted to, could help the process — by forming a new Accepting Houses Committee and granting “best rate” bill discount privileges to its members. “Prestige and standing” would then not be a problem.


(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)