Critics denounce the City and its institutions as vampires, but this view fails to recognise the structural weaknesses of the economy. Daniel Ben-Ami drives a stake through the perception and examines the outlook for the financial sector.
I?f there is one image that conjures up the popular view of the City of London it is probably the vampire. Not the sexy bloodsuckers in such American teen television series as True Blood or Buffy the Vampire Slayer but the old-fashioned, smelly, ugly, Nosferatu.No doubt such images will come to the fore again this week as the big British banks start to announce their annual results. Commentators will denounce the banks' substantial profits and the fat bonuses to senior bankers. The public, their incomes squeezed by stagnant pay and rising inflation, will feel annoyed.
But it would be wrong for those who work for financial institutions to lambast the public's criticisms as ignorant. For a start, politicians have done a lot to stir up feeling against "greedy bankers". Such rhetoric is a convenient way for politicians to divert attention from their own failure to tackle Britain's economic weaknesses.Economists, although not prone to vampire imagery, should also bear a share of the blame. They typically focus on the role of the banks in the financial crisis and subsequent recession. It seldom occurs to them that the problems in the financial sector could be symptomatic of deeper structural problems. Nor are journalists immune to criticism. Many have indulged in anti-banker hyperbole. Matt Taibbi, a writer for Rolling Stone magazine, condemned Goldman Sachs as a "giant vampire squid" in an article entitled "the great American bubble machine". He was talking about Wall Street, but similar sentiments are rife in Britain. (article continues below)
None of this is to deny that those who work in finance bear some responsibility for the crisis. They certainly played a role. But the popular obsession with their misbehaviour is one-sided.
In any case the critics seem unaware of the nasty historical antecedents to their arguments. Blood-sucking caricatures of bankers were staple images in such anti-semitic publications as Der Stürmer, a weekly tabloid newspaper in Nazi Germany.
This is not to suggest that the critics of the banks are anti-semitic, let alone Nazi. Only that they are exceedingly casual in the way in which they describe the financial sector. Their critique is based on a loose moralism rather than any proper analysis of how contemporary finance works.
In a way this is not surprising. Few people seem to have more than a vague idea of the workings of finance. Even those who work in the sector only tend to know about their own particular areas in any detail. Most investment bankers, for example, probably know little about pensions or insurance. Most fund managers are unlikely to have a detailed knowledge of currency trading or credit default swaps.
For that reason it is worth revisiting the role of the financial system. From there it is possible to identify changes since the advent of the credit crunch in 2007 as well as the likely impact of the reforms that are due to be implemented.
The most common approach to discussing the financial sector is to describe the specific roles of different types of institution. This involves outlining the functions of banks, insurance companies, fund management groups and other organisations.
Adair Turner, the chairman of the Financial Services Authority (FSA), followed this standard approach in his chapter in a 2010 report on The Future of Finance from the London School of Economics. He outlined four core functions of the financial sector: the provision of payment services; the provision of pure insurance services; the creation of markets in spot or short-term futures instruments; and financial intermediation.
Such an approach has the virtue of providing a simple, descriptive account of what financial institutions do. But it fails to get to the analytical core of the role of the City. To locate the nub of its function a more abstract approach is needed.
At its root the role of the City is as an intermediary for capital. Its purpose is to channel capital from one party that has a surplus to another that has a deficit.
The revenues of financial institutions come from taking a "cut" from the transaction. In the case of the City the cut does not just come from British firms but from businesses worldwide. In that sense it is channelling capital produced elsewhere into the British economy.
This model of financial institutions as intermediaries is perhaps at its simplest in commercial banking. Savers put their money in the bank in the hope of withdrawing a larger amount, by accruing interest, in the future. Borrowers take out loans so that they can either finance consumption or investment for the future. The bank earns revenue from the margin between the rate at which it takes in money and the rate at which it lends it out. Strictly speaking it creates no value itself.
Capital markets, whether in bonds or equities, provide a different way of achieving the same objective. They are places in which investors in companies can be matched with firms that need capital. Other institutions, including investment banks and stockbrokers, are also involved in this process.
Investment management, too, can be understood in this framework. its investors are suppliers of capital who provide resources to companies that need it. Fund groups take a fee for the intermediation service they provide.
This general pattern for financial activity has become more complicated since the 1970s. Although financial institutions remain as intermediaries of capital they have also increasingly become intermediaries of risk.
Take the derivatives market as an example. One party in a transaction might want to hedge against a rising dollar and the other against a falling dollar. A financial institution could provide the channel through which both parties take on the transactions they want. Essentially, the deal can be seen as a transfer of risk. Even if individual deals do not match precisely, the point of the market is to allow companies or individuals to buy some risks and sell others.
Of course, there have always been specialist institutions providing risk management services - that is the role of the insurance industry. What is different about the recent period is that the risk management function has become more central to the role of the City. As companies become more focused on protecting themselves against risks - including interest rate risk and foreign currency risk - the financial system has reshaped itself to provide such services.
This abstract model helps explain why the critics so often misunderstand the City's role. First, they focus on the circulation of capital, essentially the role of the City, without paying attention to its production. They fail to see that the one cannot be properly understood in isolation from the other. If finance plays a destabilising role, it probably also says something about its relationship to the real economy.
Second, the risk management function of the City is often misunderstood as reckless gambling. This is the origin of the common metaphor of the financial sector as a giant casino. Such critics fail to see that the impetus behind these markets is to allow financial institutions and companies to transfer risk. It is rarely about taking the most reckless possible bets.
Judging from the immense amount of talk about reforming the banking system, it could easily be assumed that it has been fundamentally transformed. But even a cursory examination suggests there is more talk than action. For example, the government's Independent Commission on Banking does not even report until September. After this it will no doubt take time for the government to consider its recommendations and enact legislation.
To gauge how the financial sector has changed it is necessary to recap on the events of the past three years. Banking has been the main focus of attention over that period, although other types of financial institutions have also felt the impact. As John Yakas, a fund manager at Polar Capital, says: "Banks were the centre of the storm."
Until the middle of 2007 everything appeared to be going well. Gordon Brown, in one of his final acts as Chancellor, said in his annual Mansion House speech that the City had created: "an era that history will record as the beginning of a new golden age for the City of London". He was far from alone in taking such a view. The Bank of England's Financial Stability Report opened its April 2007 issue with the words: "The UK financial system remains highly resilient". It did go on to note the risks posed by problems in the American subprime mortgage market but overall it was sanguine about the risks.
Soon afterwards several problems began to become apparent. Liquidity started to dry up in European credit markets as a result of global concerns. In Britain, Northern Rock, a medium-sized mortgage lender, was the first high-profile casualty. After a run on the bank the institution was nationalised in February 2008.
At that point it was widely hoped that the Northern Rock debacle was a one-off event. But the worst was yet to come. The collapse of Lehman Brothers, a Wall Street investment bank, in September 2008 triggered a crisis which threatened the integrity of the global banking system. Within days Lloyds TSB had taken over the troubled HBOS banking group, which operated Bank of Scotland and Halifax. Bradford & Bingley, another mortgage lender, was nationalised and its operations sold to Spain's Santander.
But further rescue packages failed to stabilise some of Britain's core financial institutions. Both Lloyds and RBS were part-nationalised.
By early 2009 the banking system had undergone some spectacular changes. In a move that would have been unthinkable before the crisis, some of the best-known names in British banking were taken over by the state.
However, beyond this point the changes become less visible. Despite all the talk the banking system has not been broken up. As yet there is no break-up of the largest financial institutions.
Perhaps the biggest changes relate to liquidity and capital requirements. In response to the financial crisis the Bank for International Settlements, a central bank for central bankers, has agreed stricter capital requirements. Essentially, commercial banks have to increase the amount of core capital they hold relative to their total lending. Although what is known as Basel III will not be fully implemented until 2019, it is already having a significant effect. Simon Hills, an executive director of the British Bankers' Association, estimates that the larger British banks increased their tier one capital from 7.3% at the end of 2007 to 12.3% by the middle of 2010.
While there is widespread agreement that this increase in core capital is necessary, it has caused problems. The banks are caught in a vice where, on the one hand, the government is urging them to be more conservative in their lending while, on the other, they are being asked to lend more to smaller businesses. This is just one of many inconsistencies in government policy, both from the previous Labour administration and the coalition, in relation to the banks.
Banks are in the peculiar position of both receiving subsidies, often hidden, from the state while being forced to hand over additional tax revenue at the same time. Perhaps the biggest boon for the banks is the climate of low interest rates. This means they can borrow at a lower rate but their lending rates have not fallen correspondingly. The yield curve has steepened and spreads have widened. Richard Batty, a strategist at Standard Life Investments, notes that: "the monetary environment is more conducive to making profits".
Of course, the converse also applies. If interest rates start to rise, the banks will lose this advantage, and indeed their earnings could be squeezed. This is probably one reason why the Bank of England is reluctant to raise rates despite exceeding its inflation target many times recently.
Meanwhile, the government is also trying to raise money from the City through its bank levy. Last week George Osborne, the Chancellor, announced an extra £800m tax on the banking industry. That means the banks will have to pay a total levy of £2.5 billion to the government this year.
All of this has put Project Merlin, an initiative involving the banks and the government, under strain. The scheme involves a compromise between the two sides. Bankers offered restraint on bonuses and more extensive lending in return for the government eschewing tighter regulation and higher taxation. In the event both sides have made token concessions, such as the banks' agreement to lend more to small and medium-sized businesses, but tensions remain.
On the investment banking side some types of financial instruments, such as asset-backed securities and collateralised debt obligations, have either disappeared or been scaled down. The Basel capital rules have perhaps had less effect so far than in commercial banking but that could change. One senior City banker told Fund Strategy that derivatives trading could fall significantly as it becomes subject to tougher capital requirements. The regulators are also pushing derivatives trades away from over-the-counter transactions - direct trades between the two parties involved - towards exchange-based trading.
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