The City is surviving − even thriving

At the end of the first year of life outside the EU – one doubly traumatised by a second year of coronavirus pandemic − the City of London remains the premier, global financial market. And there are reasons for optimism about its future, says Victor Hill.

A decent year

Despite the initial bout of Brexit-induced melancholy at the beginning of this year, compounded by the uncertainties wrought by the coronavirus pandemic, the mood in the City of London this Christmas is upbeat.

Financial services were almost entirely excluded from the free-trade agreement between the UK and the EU which came into force on 1 January this year. And without “equivalence” status, London-based institutions were rendered unable to service the needs of their European clients.

Yet there has been no “Brexodus” of City workers. In fact, the flow of bankers, fund managers and traders moving from the UK to the EU went into reverse this year, according to EY Financial Services Brexit Tracker. True, 44 percent – that’s 97 out of 222 financial- services companies monitored by the Tracker – have moved or expect to move some operations to Europe. And post-Brexit negotiations between the UK and the EU on financial services have dragged on this year. A proposed memorandum of understanding concerning how the two jurisdictions can work together has been left unsigned. Yet all the major players have chosen to remain in the UK.

London remains the hub of financial services in Europe, despite the ambitions of Paris and Frankfurt to upstage it. Paris has attracted 2,800 relocated staff, followed by Frankfurt (1,800) and Dublin (1,200). All told, the City has directly lost fewer than 8,000 jobs to the EU – much fewer than the ‘doomsayers’ who predicted up to 200,000 job losses. And those job losses have been more than outweighed by the sector’s continued growth elsewhere.

Meanwhile, the eurozone’s top banking groups have demanded long-term access to the City’s multi-trillion-dollar derivatives market, despite Paris and Brussels openly articulating their intention to seize business from London. In a joint letter released on 27 November, EU financial bodies said that they face a “cliff edge” unless Brussels extends exemptions which permit EU financial institutions to conduct trades in London and in other international financial markets. The letter was signed by the International Swaps and Derivatives Association, the European Association of Cooperative Banks, the European Banking Federation, the Futures Industry Association, the Global Financial Markets Association and the Nordic Securities Association.

They are all concerned that if temporary arrangements are allowed to expire at the end of June 2022 without the London market being granted “equivalence” status, their members will face increased costs, increased operational risk and the possibility of “trapped” or “stranded” assets. European banks still depend on London’s estimated €660tn derivatives settlement market. Separately, the EU Commission in Brussels has been obliged to permit banks in the EU to continue to access London’s euro clearing market indefinitely, amid fears that cutting London off might create financial instability. The EU’s financial-services commissioner, Mairead McGuiness, has said that the EU is likely to extend “equivalence” despite the EU view that EU financial institutions are “overly reliant” on the UK for clearing services.

Any reduction in business with Europe seems to be counterbalanced by increases in business elsewhere. According to banking lobby group TheCityUK, financial-services exports to the US outstripped those to the EU in 2020 for the first time since 2016. Around 34 percent of exports by banks and financial institutions went to the US in 2020, compared to 30 percent to the EU. Total financial-sector exports to the US were just under £15bn in the first half of this year as compared with £11bn to the EU. Britain’s overall trade surplus in financial and related professional services increased by 8.4 percent to $101.7bn (£79.3bn) in 2020.

Banks getting results

British banks are in the black. Lloyds reported nine-month profits to the end of September of £5.9bn on net interest income of £11.6bn. That represented a decent return on equity of 17.6 percentⁱ. Barclays reported year to end of September profit before tax of £6.9bn on revenues of £16.8bn. Its return on equity (ROE) was 14.9 percentⁱⁱ. In October, HSBC reported a strongly increased nine-month profit before tax of £16.2bn on slightly lower revenues of £37.6bn. Their ROE came out at 9.1 percentⁱⁱⁱ.

These UK banks appear to be well capitalised, and their shares have fared well this year.

Regulation

In early November the UK Treasury published proposals for what the new post-Brexit regime of financial regulation might look like. This suggested that divergence in financial regulation from the EU is likely to be incremental and gradual rather than any ’Big Bang’. There are downside risks, however. If the UK government were to invoke Article 16 of the Northern Ireland protocol, as it has threatened to do, then financial services would no doubt come under fire from the EU in retaliation. The City is already beginning to dismantle the MIFID II reporting structure which was inherited from the EU.

In the meantime, Brussels is attempting to formulate its “capital markets union”. That would be a common rule book intended to enable companies in the EU to raise new capital more cheaply and efficiently and to enhance financial stability. Basically, the plan is that Paris, Frankfurt, Milan and Amsterdam will function as a single global financial centre. In principle that would reduce compliance costs.

In practice, however, as usual, it does not follow that a system of supranational rules works better than those imposed by national regulators. Regulation should be designed to protect and to prevent excesses by rogue operators, not to stifle innovation. And both London and Brussels are yet to come up with a coherent structure for regulating cryptocurrencies – if, indeed, that is possible at all.

Fund management – a new landscape

An estimated £1.3tn of assets under management have been shifted from London to the EU since Brexit became reality on 31 January last year. Most trading in European equities has migrated from London to Amsterdam. That said, a lot of fund managers residing in the UK are making buy and sell decisions here which are booked through subsidiary investment firms in the EU.

Rishi Sunak announced last month that the City will become the “first ever net-zero aligned global financial centre”. Pension savers now face increasing pressure to invest in green technologies and thus “green funds”. But supposedly “ethical” and “climate change-friendly” investments can be more expensive. Fund managers often charge ethical investors more. It is evident that the MSCI World ESG (Environmental, Social & Governance) Leaders Index has outperformed the standard global index over the last five years. But as interest rates rise, so the appeal of firms already paying dividends is likely to grow, and firms offering green ‘jam tomorrow’ may fall out of favour.

At the COP26 summit in Glasgow last month, Mark Carney, former governor of the Bank of England and now a climate commissioner for the United Nations, announced an alliance of 450 banks, insurers and asset managers that had theoretically committed $130tn to invest in green projects by 2050.

Flotation blues

This time last year – despite the imminent lockdowns – we were excited about a slew of new tech flotations planned for the London stock market. The actual outcomes were, shall we say, mixed. Deliveroo flopped. It came to market with a £7.6bn valuation but is now worth about £3.75bn as the competitive environment has intensified. Darktrace (cyber security and AI) soared, its shares more than doubling – and then sank; though at the time of writing, its shares are still about 25 percent above the initial offer price. Moonpig (greetings cards and gifts) flunked. The Hut Group (cosmetics) has also fallen sharply since its IPO last year.

That said, the number of new listings tripled this year to 113, and the amount of new money invested also tripled to about £50bn. After two decades of contraction, the London market is now expanding. Many of the new listings were in growth sectors such as renewable energy and logistics. This is welcome as the London market has been dominated for too long by companies in industries which look decidedly last century such as tobacco, bricks-and-mortar retail, high-street banking and fossil fuels.

It is probably too early to say whether the likes of Deliveroo have been correctly valued or not. Just look at how long it took for Ocado to convince investors that it was a flyer. Its stock languished for years before finally surging at the beginning of the lockdown in March 2020. By September last year Ocado was trading at £28.17 – that was more than 12 times the stock’s value at the beginning of 2018. The stock has fallen back since and is now trading at around £16.40.

The London advantage

The strengths that built the City in the first place still adhere. The English language, English contractual law backed up by functioning courts operating under the sanctity of the rule of law, a great time zone, support services, good IT, ample supplies of talented professionals – all these things make the City what it is. The last two years of pandemic have demonstrated that financial institutions can continue to operate even when most of their staff remain at home. Moreover, the prospect of the end of the era of near-zero interest rates means that banks can start to reprice their lending activity and (hopefully) build up deposits as savings rates rise accordingly. That will help with the obscure art of bank liquidity management.

London-based banks had £14.3tn of assets at the end of June − much bigger than those of France and Germany. And the UK’s legal-services sector is second only to that of the US. London accounts for 16 percent of cross-border bank lending globally and handles a staggering 43 percent of global currency transactions – including twice as many dollar transactions as the US. The UK insurance industry is the fourth largest in the world and the largest in Europe. What’s more, the latest Knight Frank survey claims that American investors put more than £1bn into UK real estate last month

On the negative side, the swingeing increase in corporation tax driven through by the Johnson government may give some financial institutions pause for thought before they relocate here. At least Rishi Sunak was able to reduce the levy on bank profits from eight percent to three percent in his Autumn Statement/Budget. But given a headline corporation-tax rate of 25 percent in 2023, UK-based banks will have to pay 28 percent tax on their top-line profits.

That is not particularly competitive. UK banks paid £39.6bn last year according to UK Finance – that’s almost enough to run the Ministry of Defence. Next year, given higher corporation tax and an uplift in employer’s national-insurance contributions, they will surely pay much more. London will no longer be the “automatic choice” for expanding international banks to locate – but it will remain very high up on the list.

PS

I am almost old enough to remember when City types wore pinstripe suits, black ties and bowler hats and carried umbrellas – a kind of ritual uniform which was immortalised by the great John Cleese in his Ministry of Silly Walks sketch.

I do remember when Margaret Thatcher and Geoffrey Howe abolished exchange controls (1979) and it seemed like a new era had dawned. Can you imagine that, hitherto, if we nipped over to France, we could only take £25 in our pockets?

I well remember Big Bang (1987) when the stock market was reformed. Hitherto there were jobbers and brokers and ne’er the twain could meet. After Big Bang there were just stockbrokers which were mostly bought up by (American) banks.

I can also remember Black Monday (19 October 1987) which occurred after we had struggled into work avoiding the fallen trees ravaged by the Great Storm (night of 15-16 October). It was like something out of grand opera. Trading was suspended twice and then the market was closed early at 12:30pm. The traders repaired to the pubs, shell-shocked, not knowing that they had been hit by a 27-standard deviation event.

I recall the Asian Financial Crisis of July-August 1997 – swiftly followed by the Russian Debt Crisis. The bond markets behaved in ways that the analysts regarded as technically impossible: flight to quality, anybody?

I remember watching CNN in a hotel room in Florence on the night of 14 September 2008. Were they really going to let Lehman Brothers go down? Did they have any idea of the possible consequences? My hotel room overlooked a Renaissance hospital where Leonardo da Vinci had carried out autopsies in his quest to master human anatomy. I looked out over the ornate gardens with a sinking feeling in my stomach.

And I was staggered by the complacency of markets in the run-up to the Brexit referendum, believing that a ‘Leave’ result was much more probable than commonly supposed. Then, early last year, I thought that the grip of Covid-19 had spooked the markets excessively…

Come to think of it, my life has been a succession of financial crises. But I’m not complaining. One should never let a decent crisis go to waste. And I expect to survive a few more before I’m done.

A very Merry Christmas, everybody. And cheers!

Next week don’t miss: What investors need to know about 2022.

Listed companies cited in this article which merit further investigation:

• Darktrace (LON:DARK)
• Ocado (LON:OCDO)
• Lloyds Bank PLC (LON:LLOY)
• Barclays Bank PLC (LON:BARC)
• HSBC Bank PLC (LON:HSBC)

i^ See: https://www.lloydsbankinggroup.com/investors.html

ii^ See: https://home.barclays/investor-relations/reports-and-events/results/barclays-q3-2021-results/

iii^ See: https://www.hsbc.com/investors/results-and-announcements