In the words of Gordon Brown last week, it was "not a time for outdated dogma or conventional thinking."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."
Indeed, London staffers seem certain to suffer worse than their New York counterparts. The same flexible labor market—by European standards, sacking is cheap and easy in Britain—that helped to lure overseas players to the City now means the London workforce will be the first in line for cuts. "If foreign banks are going to shed 10 to 15 percent of their staff, they are going to do it overseas because there is less political pressure," says Andrew Hilton of the Centre for Financial Innovation in London. By some reckonings, the City is set to lose 40,000 jobs this year, out of a total of some 350,000.
But the effects will be felt far outside London. The success of the City has bred an unhealthy dependence on the financial-services sector, which last year accounted for nearly 10 percent of the British economy, up three points in the past 10 years. For the Treasury, the City was a golden goose. The public's anger over rocketing bonuses—City workers shared £13.7 billion this year—was a necessary price for prosperity. Financial-services companies provided 25 percent of all corporate tax revenues in 2007—double the figure 25 years earlier.
And right now, Britain can ill afford the City's failure. Even before the latest crisis, consumer confidence was in free-fall. House prices, driven upward by City money, are falling at their fastest rate in 20 years—down 13 percent since last autumn. Unemployment, at 1.7 million already at its highest level since 1998, now looks set to hit 2 million, or 6 percent by the end of the year. Sterling has dropped 12 percent against the dollar and the euro in the past year. But don't look for a handy boost in exports of manufacturing. As financial services grew, industry shrank, shedding more than a million jobs in the past 10 years.
The big fear: that government will aggravate London's suffering, screwing down the City with stricter rules that destroy its essential character. The ban on short selling, blamed for helping to sink the banks, has already rattled nerves. "In the search for a scapegoat the regulatory environment will suffer," says Antonio Borges, chairman of the London-based Hedge Fund Standards Board. "Our concern is not with the regulators; it is more with public opinion, which drives the political process. We have seen what's happened in the U.S.; now we're afraid it could happen here."
If so, there's a chance that some players might quit Britain altogether. "There are plenty of alternative offshore centers, and the possibility [of leaving London] is always there," says Borges. "Switzerland has a long tradition of asset management, and there is no doubt they would like a larger share of the hedge-fund industry." Maybe, but there's another lesson to be learned from recent events. For the big players, it is that big countries make the best bases. Could the Swiss, for example, afford to stand behind their banks if a collapse were imminent? asks David Freud. "The country is too small to stand behind its banks. A good, solid taxpayer base is very attractive in these circumstances." As Gordon Brown has just demonstrated.