According to (pervasive but possibly apocryphal) legend, Chinese prime minister Zhou Enlai, when asked in the 1970s what he thought of the French Revolution, responded “It’s too early to tell.” As for London’s Big Bang of 1986, it is also “too early to tell” whether it was beneficial. However if the current unpleasantness turns into a full fledged credit crunch and stock market crash, we will not have to wait until 2170 to find the answer. Contrary to unanimous media gloating at the time of last year’s 20th anniversary of the event, that answer is likely to be negative.
For those too young or non-British to remember, Big Bang was the package of legislation, legal activity and Bank of England rulings, culminating in 1986, that opened the City of London to foreign competition and abolished most of what had made its financial services business unique. On the broking side, the sales function (brokers) was no longer separated from trading (jobbers.) On the banking side, all aspects of the issues and mergers business were opened to foreign competitors, with no privileges remaining for local houses. The Stock Exchange became first primarily electronic and then entirely so; the trading floor was abolished. The Bank of England’s historic regulatory function was abandoned and a statutory system similar to the US Securities and Exchange Commission was introduced. Ownership of all institutions was opened to foreigners, as was membership of the Stock Exchange, while the acceptance discounting privilege that had protected major merchant banks against financial disaster was abolished.
Much to the surprise of all concerned (at least in Britain) the result of Big Bang was to wipe out the merchant banking community and reduce London to the status of a “branch plant” city, in which ownership and control of essentially all leading participants lay overseas. This wasn’t inevitable; foreign banks have always been allowed into the New York market, and serve mainly as enthusiastic buyers of the various scams that New York financiers are so expert at developing (yes, IKB, this means you!) On the positive side (at least as far as the City’s workforce were concerned) incomes at the top end of the financial services industry soared, while those senior practitioners who were unable to compete in the new world were consoled by generous buyout terms for their partnership interests.
Before 1986, London had two periods of preeminence in international finance. The first, as is well known, was between 1694 and 1914. The second was the 1960s, when after reaching a very low ebb around World War II the City pioneered the Eurobond and Euroloan markets. Thus by 1972 most of the London merchant banks had regained a considerable international standing, and new more entrepreneurial institutions had grown up that appeared to be taking the City into new areas, particularly international private equity. The one thing missing was international equity trading; because of the appallingly prolonged exchange control regime, which did not end until 1979, London brokers had lost their pre-war expertise in international share trading and investment.
Then came the credit crunch of 1973-74, an episode almost forgotten today, judging by coverage of recent events. When followed by near hyperinflation over the next five years, this had two effects. First, it wiped out every major entrepreneur in Britain’s financial services business – Jim Slater, Oliver Jessel, Pat Matthews, they were all forced into resignation or bankruptcy. Second, it halved the capital base of the merchant banks in dollar terms, making them too small to compete effectively against larger foreign institutions. Hill Samuel’s Kenneth Keith, the best long term strategist of that generation’s merchant bankers, had foreseen the problem as early as 1970, attempting to gain a larger inflation-proof capital base through merger with the real estate company MEPC. However the problem was not at that stage extreme; as of December 1973 Hill Samuel had a larger capital base than Salomon Brothers, already among the most aggressive forces on Wall Street. By 1980 the position was very different; Salomon Brothers alone made $500 million in profits in 1982, more than the entire banking and broking City of London.
In retrospect therefore, the early 1980s was an appallingly bad time to “level the playing field” and allow aggressive foreign houses into the London market. Had the market been opened in the 1960s, preferably during the intelligent, forceful Bank of England Governorship of Lord Cromer (and accompanied by the removal of exchange controls, as Cromer wanted) the US investment banks would have had capital bases no larger than the London merchant banks. Led by Keith, Sigmund Warburg and the more entrepreneurial Slater and Jessel London houses would have proved formidable adversaries for foreign predators from the US or Europe; indeed it is most unlikely that foreign banks would ever have achieved more than a modest position.
Conversely, had London been left to grow organically until the late 1990s, the merchant banks and brokers would have rebuilt their international equities businesses on the back of two decades of high profitability and booming stock markets, with the British-designed product of privatization universally popular. By the time London was fully opened it is likely that they would once again have been competitive. In the 1980s, hobbled by small size, lack of experience with London’s new financial system and lack of expertise in international equities, the London houses were piranha fodder.
Even so, more could have been done to ensure that some protections were retained, and it is a stinging criticism of the ideologically blinkered Thatcher government and two feeble Bank of England Governors (Gordon Richardson and Robin Leigh-Pemberton) that it wasn’t. The Accepting Houses Committee was an essential mechanism to allow British merchant banks to flourish the highest credit ratings in battling much larger rivals. Single capacity, forcing brokers to go through jobbers to deal, was an essential protection for the retail investor against the sorts of scams perpetrated in late 1990s Wall Street. Moving to electronic trading removed the advantage of experience from established traders, and allowed the young, foreign and well capitalized to seize control of the market. The Bank of England as a regulator provided excellent market and investor protection, better than what followed. Switching to US modes of dealing and regulation automatically gave an advantage to the Wall Street houses experienced in such methods against the London houses accustomed to a different system.
The disappearance of the merchant banks was probably inevitable, given the timing and details of the 1980s changes, even though few saw this at the time. In any case, nothing significant was done to save them; on the one occasion in which the government and Bank of England could have been helpful, the 1995 Barings collapse, they notoriously failed to assist in any way, allowing London’s oldest merchant bank to be absorbed by an inept Dutch behemoth.
Currently, the new system has been blessed with 20 years of favorable conditions, with only moderate downturns in 1990-92 and 2000-02. It has produced enormous wealth for participants, and even the effect of foreign ownership has been mitigated by the usual investment banker tactic of siphoning off most of the profits before they reach the shareholders. To an even greater extent than in New York, the financial services business has enormously increased its share of output and earnings. While it remains questionable how much of its additional output represents real value and how much successful rent-seeking, even that consideration should not unduly deter Britons, since a high percentage of the rents are being sought from foreign companies and institutions.
It now remains to be seen what will happen in a serious downturn, which we may or may not be entering but will undoubtedly experience soon. Hedge funds, particularly those with misguided quantitative strategies, will be the first to go; they have been achieving sub-par investment returns for a number of years now, the sector being sustained only by the aggressive salesmanship of their managers seeking the holy grail of a lightly taxed 20% “carried interest.” Without profits, their carried interest is worth nothing, and their investors will start trying to recapture the remnants of the invested money.
Private equity, too, is likely to go into a prolonged downturn. Here the extraction of the “carried interest” by the managers before companies are sold will leave many funds in a hopelessly illiquid position, unable to pay the staff. This in turn will produce a glut of private equity positions to be sold, which will produce a catastrophic drop in their value. Except for the most long term oriented funds specializing in the more arcane emerging markets, it is likely that following a downturn private equity investment will be correctly perceived as an activity that adds little or no economic value; employment levels and remunerations in the sector will thus be decimated.
Trading desks will make large losses; they have been sustained by an ever increasing proliferation of derivative products that fail to offer the security they pretend, and are highly illiquid in a downturn. In a bear market, there will be no buyers for such products; the burnt child, if it survives at all, having learned to dread the fire. Consequently there will be few trader jobs other than in the most mundane sectors.
Judging by past patterns, a downturn in London’s “investment banking” business will last at least 2-3 years, producing huge and unanticipated losses in each year, followed by a drastic decline in activity. It will also no doubt result in the arrest, conviction and imprisonment of a number of leading practitioners; ethical standards in the new City have slipped to those of Wall Street and it will be no surprise if Wall Street-style prosecutions, spurred on by a vengeful investing public, bring some big names low.
At that point, the foreign shareholders who control today’s London houses will have three choices. They can keep the London houses going, in the hope that in a mass desertion of the business by others they can pick up market share. They can bring the businesses back to their head offices, recognizing that in a trader’s world such businesses require little specialist expertise that is not readily internationally available, and that bringing the business closer to its controllers is more important with today’s communications than its physical proximity to the markets. Or they can close the businesses down altogether.
If sufficient players choose either of the second or third options, London will cease to be a top tier financial center. At that point the only beneficiaries of the special foreigners’ tax deal, so obnoxious to those of the British public who know about it, will be the Russian mafia. Since attracting yet more of the Russian mafia is probably not a British objective, the tax deal will then go.
After the 2000 peak, I believed that a lengthy bear market would lead to the recreation of something like the London merchant banks, as foreigners pulled back from the market. After all the Flemings, the Schroders and the Hambros were all still present in London, with relatively recent memories of merchant banking, and plenty of money. At this stage, the opportunity has probably gone; by 2012, when new merchant banks could successfully be established as the market began to recover, it would be 25 years since Big Bang and the senior potential participants would all be 60 plus.
For those not subject to the penal British taxation that will be exacted after the financial behemoths depart, it may be thought fairly unimportant that London ceases to be a premier financial center. Florence and Amsterdam both lost their top tier status, yet both cities remain prosperous, their attractions increased by the houses left to posterity by their bankers. Regrettably, the Luftwaffe and the developers destroyed most of the best bankers’ architecture in London; it seems unlikely that in 2200 tourists will be visiting to see the post-1950 rubbish. Even as a museum, therefore, the City’s future appears limited.
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(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.)