Political Economy: The City of London as Savior of E.U. Finance

It is perhaps too much to expect the Conservative-led government in Britain to lead any initiatives on Europe, given the orgy of self-destruction in the party over whether Britain should stay in the European Union. But insofar as David Cameron manages to get some respite from the madness, he should introduce a strategy to enhance the City of London as Europe’s financial center.

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 its 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 Union to swing behind a pro-London strategy may, on the face of it, seem like pie in the sky. Many people blame the finance industry for the financial crisis. So how could they be part of the solution? What is more, Continental Europeans have long tended to be suspicious of financial markets.

Hence, the plan by 11 E.U. countries (not including Britain) to apply a tax on all financial transactions. Hence, too, the recent decision to cap bankers’ bonuses throughout the Union (over London’s objections) and a plan, so far not agreed upon, to do the same for fund managers.

The oddity about those rules is that they do nothing to address the causes of the financial crisis. Trading in financial instruments was not responsible for the crisis. Nor were fund managers. And although banker compensation does bear some of the blame, the so-called solution is cockeyed. Banks will react to bonus limits by pushing up fixed salaries — which will make their finances more vulnerable when the next crisis hits.

Meanwhile, the financial transaction 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 extraterritorial implications. Any trading involving financial instruments issued by entities in the 11 countries would be caught by the tax, even if the transactions took place entirely in London.

Despite those obstacles, 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 Europe has a banking crisis, not a capital markets one.

Banks have lent too much money to clients who cannot 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 this year. Banks fund themselves with deposits and other short-term money. As a result, they do not lend long term, or if they do, they expose themselves and taxpayers to huge risks if liquidity dries up.

The contrast between the United States and Europe is stark. In the United States, 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 securitization, where corporate loans and mortgages are bundled up and sold to investors in the capital markets. Nearly half of long-term financing there is via securitization. In France and Germany, it is only 2 percent and 3 percent, respectively.

The corporate bond market is also in its infancy in Western Europe. Only 21 percent of the debt financing for nonfinancial companies comes from bonds. In the United States, it is 45 percent.

With the European Union’s banking system haunted by zombies, its excessive reliance on banks to provide financing 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 securitization 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 toward a banking union will lead to even tighter regulation. The E.C.B., which will take over bank supervision next year, will first subject lenders to scrutiny to see whether they are hiding bad debts. It understandably does not want banks blowing up on its watch.

What is more, if Germany eventually agrees to backstop banks in the rest of the zone, the quid pro quo could well be that those lenders will be required to have fortress balance sheets. Berlin will want the chance of that backstop’s ever being used to be virtually zero.

All of 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. Mr. Cameron should start campaigning for that now. If he can push through such an agenda, it will not just be good for Britain; it will be a powerful argument in any future referendum for staying in the European Union.

Hugo Dixon is editor at large of Reuters News.

Article source: http://www.nytimes.com/2013/05/20/business/global/the-city-of-london-as-savior-of-eu-finance.html?partner=rss&emc=rss