Dark Days For the City of London

In the words of Gordon Brown last week, it was "not a time for outdated dogma or conventional thinking." Too right. This was a radically fresh approach from the British prime minister. A Labour government that had conspicuously befriended London's moneymen was about to take a controlling stake in their principal business. In all, Brown promised £500 billion in a package intended to recapitalize the country's eight leading banks and ensure their survival. The price: a loud voice for the government in their lending policies, dividend payouts and executive pay. The glory days of independent banking are over.

The great global credit crunch has humbled London. The latest move signals not only the end of the banks' swaggering, it's also the end of a whole freewheeling, bonus-driven culture that set the City apart from the rest of Europe for the past two decades and helped Britain to enjoy a record 16-year spell of unbroken economic growth. The same charms that lured so many foreign banks to London—little oversight by the authorities and flexible labor markets—are causing its downfall. The doom-mongers talk now of a future City burdened with new regulations and robbed of its competitive edge over New York.

For sure, the London that will emerge when the dust settles will be a very different place. The much-vaunted "Big Bang" of 1986, the deregulatory splurge that opened up London's markets to overseas players, set the City on course to challenge New York as a global financial hub. By last year London had more than 34 percent of the world's foreign-exchange market and more than half the world's trade in foreign equities. Foreign businesses, whether Russian or Middle Eastern, looking for an overseas flotation, flocked to the London Stock Exchange. These days London plays host to 254 foreign banks, far more than either New York or Frankfurt.

Its popularity is easily explained. London's charms begin with the English language and a handy place in the word's time zones midway between America and the Far East. But that's just for starters. The real attraction has been a laissez faire commercial culture in the City. "In the past, it's been about following a set of ethical and commercial principles rather than setting out to change the mechanics of the market," says Alan Morrison, a former London banker now teaching at the Saïd Business School at Oxford University. Few rules; more trust. By contrast, American bankers have groaned at the mass of legislation that followed the flurry of scandals earlier in the decade.

In turn, such regulatory indulgence fostered the exploitation of smart new financial products and practices. Looking for a hedge fund? Last year 80 percent of Europe's business, measured by assets under management, was in London, and almost 20 percent of the world total. More important, London enjoyed a 43 percent stake in the world's booming market for standard "over the counter" derivatives (which account for the vast majority of the total $500 trillion global derivatives market), the so-tricky instruments that lay behind the banking smash of the past year, according to International Financial Services London which collects data on dealings in the City. No surprise that the giant U.S. insurer AIG, rescued by the U.S. government last month, chose London as the base for its disastrous credit derivatives business, AIG Financial Products.

What a difference a year makes. Last year the London Stock Exchange saw 177 foreign IPOs. The figure to date for 2008 stands at barely 30. "Banking in London is going to shrink," says David Freud, former vice chairman of UBS Investment Management and author of a recent study of the City. "We are going back to a much simpler financial world." Forget all that fancy financial engineering. "Derivatives will be smelled from every angle," says Freud. "There will be fewer, simpler and more standardized products that you won't need a Ph.D. to create, so some of the high-end jobs will cease to exist."