From the April 2007 issue of Research Magazine • Subscribe!

April 1, 2007

London Calling

Pitting an enervated Brit against a brash, self-confident Yank is a frequent theme in post-World War II, post-Empire British literature, appearing in spy thrillers by John LeCarr? as well as in more serious novels by the likes of Graham Greene and Ian McEwan. However cultured, articulate or cynical, their British characters are strangely cowed, or awed, by the drive and vitality of their trans-Atlantic cousins.

It may be a shop-worn clich?, but it seems relevant when British government officials, market regulators and financial markets professionals discuss the recent McKinsey report on the future of New York City as the finance capital of the world, commissioned by New York Mayor Michael Bloomberg and Senator Charles Schumer.

On the one hand, they find it hard to conceal exultance and almost childish pride. The report, which came out earlier this year, warns that the Big Apple's dominance in financial services is facing a stiff challenge from London -- so much so that it may lose its global leadership position within a decade. And, if this weren't enough in and of itself, it presents the U.K. experience as something the United States should consider following.

During a recent trip to London, no host official could resist for long mentioning "the McKinsey report." But their triumphalism was not always unalloyed. "The McKinsey report means that the gloves are coming off," says Anthony Belchambers, chief executive of the City's Futures and Options Association, an industry group whose members include all of the world's top financial institutions.

But Wall Street may at last be waking up to the threat posed by London, and this is bound to make life more difficult for the British capital going forward.

Undeniable Success

So far, it has been a highly successful run -- all the more so since it came about unexpectedly.

In the early and mid-1990s, the City of London, Britain's ancient financial hub, appeared to be on the ropes. The pound was reeling from a disastrous devaluation in 1992, which was when George Soros' Quantum Fund famously appropriated $2 billion of Bank of England money in a single weekend. The London real estate market was depressed and the newly built Canary Wharf financial center was in bankruptcy. On the continent, Frankfurt was emerging as the financial capital for the new single European currency, the euro. Next door, Dublin was fast luring away financial service companies with tax breaks, cheap office space and a reasonably priced, English-speaking workforce.

Yet, today's London is Europe's unchallenged financial capital. It has definitively outstripped all of its European competitors and now competes directly with New York and Tokyo, says Michael Charlton, chief executive of Think London, the city's investment promotion agency.

"We like to think it is the most international of the three," he says.

It's Charlton's job to say this, of course, but in some ways London has indeed started to outstrip New York. It has long been the global leader in foreign exchange trading, Eurobond issuance and commercial insurance. Adding to this is a dramatic success in attracting international listings to the London Stock Exchange and in revitalizing derivatives trading on the London International Financial Futures and Options Exchange (Liffe).

Last year, companies raised 29.4 billion pounds, or nearly $58 billion, in initial public offerings on the LSE. To put this sum in perspective, it is nearly 50 percent more than was raised on the New York Stock Exchange, and almost as much as on the Big Board and Nasdaq combined. Whereas in the late 1990s, New York was an unquestioned leader in global IPO issuance, London is now running neck and neck -- and pulling ahead of New York in attracting foreign companies. The LSE's Main Market, where established companies list, saw 30 international IPOs in 2006. At the same time, AIM, an alternative investment market created in 1995 to list small and emerging companies, attracted 77 foreign IPOs, including 21 companies based in the United States. LSE now claims that AIM, established in 1995, is the world's most successful growth market.

It is definitely a sign of LSE's success that Nasdaq made a hostile bid for it -- which was clamorously rejected earlier this year. NYSE, on the other hand, is taking over London-based Euronext-Liffe, which in addition to the futures and options exchange consists of four continental bourses, the national stock markets of France, the Netherlands, Belgium and Portugal.

The City is also now a true hub for global financial companies. According to Alderman John Stuttard, the Lord Mayor of the City of London, over 200,000 foreign nationals from all over the world now work in the city's financial services sector.

Zero-Sum Game

Since London is a gateway to Europe, most top and even second-tier financial institutions will need a presence there. Just because Merrill Lynch or Citibank are expanding their staffs in London poses no threat to New York, admits Think London's Charlton.

However, it can become a zero-sum game when already established companies choose from which location they want to run their international business. In some cases, London is starting to win business from New York City. Moreover, a growing number of hedge funds and private equity companies now choose to run out of London.

London's success in winning international business, says FOA's Belchambers, is all the more impressive since it is not backed by an enormous, $12 trillion-strong economy the way New York is. The U.K. economy may be the most successful major economy in Europe, with consistently the fastest growth among its peers, but the size of its GDP is only a fraction of America's.

To maintain competitiveness, therefore, London needs to work a lot harder than New York, and it does. The McKinsey report singles out the Sarbanes-Oxley act for discouraging foreign companies from listing in U.S. financial markets. Put in place in 2002, in the wake of the collapse of Enron and a slew of other corporate malfeasance scandals in the United States, the law bolstered corporate governance, strengthened internal controls and required more extensive audits for publicly traded companies.

However, SOX is only part of the problem, and McKinsey, along with several other critics, pointed out various other concerns which handicap New York City. In particular, the regulatory environment in the United States is remarkably complex and convoluted, with federal, state and industry self-regulators adding to the red tape. In the U.K., on the other hand, the patchwork of nine different regulators was replaced in the late 1990s with a single entity, the Financial Services Authority.

The FSA, although created by the incoming Labor government in 1997, applies what it calls a light touch to regulation. It has adopted a principle-regulated framework, based on 11 fairly general high-level principles of proper conduct for financial institutions. It is working to get away from a more detailed -- and intrusive -- rules-based regulation that prevails in the United States.

A Short-Lived Splash

While the British have clearly studied the McKinsey report extensively, it seems to have produced only a short-lived splash in the United States. It may result in some gradual easing of Sarbanes-Oxley rules down the road, especially since it confirms some earlier findings, but a major overhaul of U.S. financial regulations is probably not in the cards. And it is not inertia or vested interests that are hampering reform.

To begin with, New York City by no means finds itself on the edge of the precipice. Mayor Bloomberg may fret about the future, but at present, the city is raking in huge tax revenues from Wall Street. The salaries and bonuses paid by New York financial firms also underpin the city's stratospheric real estate prices and rents, and explain why they are holding up even as many other regions of the country are experiencing much softer property markets. And while some hedge funds like to be located in London, it is still Greenwich, Conn., that is the hub of global hedge fund activity.

But more to the point, the tighter U.S. regulatory environment may not be such a bad thing. Rather than standing in the way of reforms, SOX is actually a product of reform and a response to a very real problem that arose earlier in this decade. For all the criticism it is facing at home, many of its aspects have been gradually embraced abroad. The principle of tighter corporate governance and more reliable auditing has spread around the world, from Hong Kong to India and from Mexico City to Brussels.

As to the U.K., its lax regulation is wrought with danger. The country's financial markets have had their own share of scandals and disasters. In fact, some of the world's most clamorous collapses in the past couple of decades emanated from the U.K., including those of Robert Maxwell's media empire, Barings and BCCI. Accounting firm BDO Stoy Hayward claims that in 2006 the number of fraud cases in the country jumped by 40 percent from 2005, to 295, and involved some 1.4 billion pounds.

Good Times, Bad Times

While AIM attracted many foreign and domestic companies, it is certainly no Nasdaq yet. There has been no Microsoft or Google among its listings. Most are small and many are trading well below their IPO price.

Worse, the real test of U.K. regulatory principles may lie ahead. After all, these have been exceptionally good times. For the past quarter of a century, financial markets have been on a spectacular run. Developed economies have experienced only mild recessions, and even though in Asia crises have been relatively frequent, disaster has been avoided -- sometimes narrowly. During the current financial market rally, which began in 2003, when London really came into its own as a financial hub, global liquidity has been remarkably plentiful, giving both good and bad companies a very wide margin for error.

This is likely to change at some point in the future, and it will be interesting to see how some of the companies listed in London will fare then. Both the Main Market on the LSE and AIM have attracted many companies from the Middle East, India, Pakistan, China, Russia, Kazakhstan, Latin America and elsewhere. Here is just one example. Nearly one-third of the 11 billion pounds raised by foreign IPOs in the Main Market last year came from last summer's issue by Russia's Rosneft. Oil prices have been extremely high and state-owned Rosneft has been very profitable. But it should be remembered that Rosneft's main productive assets were removed by the Russian government from Yukos Oil Co. in highly questionable circumstances, to put it mildly. Russian companies defrauded foreign investors when they ran into difficulties in 1998, and there have been few changes in corporate governance since.

Which brings up another factor -- political risk. By virtue of his position, John Stuttard, the Lord Mayor of the City of London, is an advocate of all financial institutions in the U.K., domestic as well as foreign. He is fond of repeating that he is a businessman, not a politician, and has no political agenda. He has impeccable credentials as a former partner at PriceWaterhouseCoopers. Even his previous stint in government is beyond reproach: He spent two years working on privatization issues in Margaret Thatcher's cabinet.

The boss of Greater London, on the other hand, is Ken Livingstone, whose most recent commercial transaction was a deal with Venezuela's Hugo Chavez to get below-market oil for London's public transportation network. Unlike Chavez, Livingstone has not been nationalizing private sector companies, but when choosing between New York and London, some financial institutions may be forgiven if they demur at quitting a city run by self-made billionaire Bloomberg for the one administered by Red Ken.

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Alexei Bayer runs KAFAN FX Information Services, an economic consulting firm in New York; reach him at abayer@kafanfx.com. His monthly "Global Economy" column in Research has received an excellence award from the New York State Society of Certified Public Accountants for the past four years, 2004-2007.

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