It is perhaps too much to expect Britain’s Conservative-led government to lead any initiatives on Europe, such is the orgy of self-destruction in the party over whether the UK should stay in the European Union. But, insofar as David Cameron manages to get some respite from the madness, he should launch a strategy to enhance the City of London as Europe’s financial centre.
Britain has in recent years been playing a defensive game in response to the barrage of misguided financial rules from Brussels. It now needs to get on the front foot and sell the City as part of the solution to Europe’s problems. The opportunity is huge both for Britain and the rest of Europe.
The chance of getting the EU to swing behind a pro-City strategy may, on the face of it, seem pie in the sky. Many people blame financiers for the financial crisis. So how could they be part of the solution? What’s more, Continental Europeans have long tended to be suspicious of financial markets.
Hence, the plan by 11 EU countries (not including the UK) to apply a tax on all financial transactions. Hence, too, the recent decision to cap bankers’ bonuses thoughout the EU (against London’s objections) and a scheme, so far not agreed, to do the same for fund managers.
The oddity about these rules is that they do nothing to address the causes of the financial crisis. Trading in financial instruments wasn’t responsible for the crisis. Nor were fund managers. And while banker compensation does bear some of the blame, the so-called solution is cock-eyed. Banks will react to bonus limits by pushing up fixed salaries – something which will make their finances more vulnerable when the next crisis hits.
Meanwhile, the financial transactions tax could gum up markets so badly, pushing up the cost of capital and constricting growth, that even its supporters are having doubts. Britain is rightly trying to challenge the plan through the courts because of its extra-territorial implications. Any trading involving financial instruments issued by entities resident in the 11 countries would be caught by the tax even if the transactions took place entirely in London.
Despite the headwinds, Britain has a genuine opportunity to turn things around. To do so, it must challenge the conventional script, under which old-fashioned banking is seen as good and capital markets bad. The truth is that Europe has a banking crisis, not a capital markets one.
Banks have lent too much money to clients who can’t pay it back. Their balance sheets were too weak to start off. Now they are unable to lend to the real economy, throttling growth.
Banks are dangerous beasts. They are not well suited to provide long-term finance, as the Group of Thirty, an influential financial policy group, pointed out in a report earlier this year. Banks fund themselves with deposits and other short-term money. As a result, they either don’t lend long term; or, if they do, they expose themselves and taxpayers to huge risks if liquidity dries up.
The contrast between America and Europe is stark. In the U.S., banks provide only 19 percent of long-term financing, according to the McKinsey Global Institute. In big European countries, they provide between 59 percent and 71 percent.
America is a much heavier user of securitisation, where corporate loans and mortgages are bundled up and sold to investors in the capital markets. Nearly half of long-term financing is via securitisation. In France and Germany, it is only 2 and 3 percent respectively.
The corporate bond market is also in its infancy in Western Europe. Only 21 percent of the debt financing for non-financial companies comes from bonds. In America, it is 45 percent.
With the EU’s banking system haunted by zombies, its excessive reliance on banks to provide finance is dragging down the whole economy. It is telling that the European Central Bank thinks that the way to get loans flowing to small businesses in peripheral countries is to revive the securitisation market.
Overdependence on banks is not just a short-term problem. Even when the euro crisis is finally over, banks will be unable to do a good job of funding industry. They are rightly being required to hold bigger capital and liquidity buffers, which will push up their costs.
The euro zone’s half-hearted move towards banking union will lead to even tighter regulation. The ECB, which is to take over bank supervision next year, will first subject lenders to scrutiny to see if they are hiding bad debts. It understandably doesn’t want banks blowing up on its watch.
What’s more, if Germany eventually agrees to backstop banks in the rest of the zone, the quid pro quo could well be that these lenders are required to have fortress balance sheets. Berlin will want a virtually zero chance of that backstop ever being used.
All this means that the only way of getting a healthy European financial system is to build up its capital markets. This is a huge opportunity for the City, as the bulk of the business would be routed through London. Cameron should start campaigning for this now. If he can push through such an agenda, it won’t just be good for Britain; it will be a powerful argument in any future referendum for staying in the EU.