15 May 2002
Speech by the Economic Secretary to the Treasury,Ruth Kelly MP on the Social Market Foundation - London's Future as a centre for investment banking
We are here today to discuss London's future as a centre for investment banking.
But first, a bit of history.
London's history as a centre for investment banking stretches back over several centuries. In the 20th, the industry survived periods of great turbulence and change: the great depression, the 87 crash, even ?the death of gentlemanly capitalism?.
Thomas Jefferson said that banking establishments, especially ones of some duration, are more dangerous than standing armies. But London has never been an establishment in the sense that Jefferson used the word. London is an open market. There have been foreign banks in London at least since the Medici's in the 14 hundreds and there are currently 477, with assets totalling more than £1,700 billion. This is a clear signal of the vitality of a robust and competitive market - with roots in the UK economy and branches in the rest of the world.
It is this tradition of open, competitive markets that I see as London's dominant characteristic and its greatest asset going forward. Today we are here to discuss the impact of the regulatory regime; the foreign ownership of investment banks in London; conflicts of interest faced by banking analysts; the challenge of the Euro; and the opportunities available in the European single market. Openness to competition, openness to trade, openness to audit and examination, openness to change, are common themes running through each of these areas.
It is in all of our interests to see an effectively functioning investment banking industry, allocating investment efficiently, and driving higher levels of growth across the wider economy.
Achieving that aim must be our central and shared objective. We all have a part to play. I would like to take this opportunity to set out what role I believe Government should play as ?intelligent sponsor? of the UK financial services sector. The Treasury has an interest as the industry's advocate in Government and elsewhere, as the custodian of regulatory legislation and, fundamentally, as an economics ministry - promoting efficiency and sustainable growth. It is this last that must define the role we play.
Why do we want a strong, successful financial services sector? For the employment and the revenue, certainly. And also because we can all take pride in an industry that is a world leader, enabling the UK to occupy a welcome position as the world's number one exporter of financial services. But the basic truth is that we can't be interested in the industry primarily for its own sake. What matters to an economics ministry is value adding activity that contributes to UK GDP. Financial services are there to provide services to consumers and allocate capital efficiently in the economy. If they are not doing these things as well as they should, then the Government's sponsorship role will be to ask why. Indeed, if it isn't doing these things well, the industry ought to be asking itself why it is operating inefficiently and missing out on market opportunities.
In short, our attitude is not ?our industry: right or wrong?. Intelligent sponsorship does not mean special pleading for special interests. That isn't in the interests of the individual, of the wider economy, or indeed of the industry itself.
I believe there is a virtuous circle to be drawn here. Intelligent sponsorship means acting as advocate: arguing the corner in Whitehall, in Brussels, the WTO and across other international platforms; opening up markets; and ensuring the industry's interests are taken into account in decision making on wider economic and infrastructural issues. But it also means acting as critic when the industry doesn't appear to be delivering as well as it should. That is why we commissioned Don Cruickshank to look at competition in banking and referred the SME market to the Competition Commission; that is why we asked Paul Myners to look at institutional investment; and Ron Sandler to look at the long term savings market. It also means we will take a critical look at the obstacles that Government may have placed in the way of an efficiently functioning market - Paul Myners? recommendation to replace the Minimum Funding Requirement for pensions funds is a good example of this.
The reality is this: intelligent sponsorship is a form of partnership between the industry and Government. It is a partnership driven, fundamentally, by the need to create an environment in which the industry is able to deliver the very best it can, to the individual and corporate consumer of financial services, and to the economy as a whole.
So it is not a question of the Government being only ?pro? one side or another, but a question of getting the balance right, creating a fair and efficient financial services market. That means we need to understand how the financial services industry operates, what is working well, and where there might be problems. One reason we need to have this understanding is so that we can get the regulatory regime right - protecting consumers without stifling innovation or reducing competition.
Regulation is an important element of the economic climate in which the financial services industry operates. The Government's role is to establish a legal and institutional framework which protects customers and maintains confidence in markets, without creating an unnecessary burden on companies or inhibiting their ability to contribute to economic growth. It is not for Government to involve itself in day-to-day regulation. Our approach relies on openness, transparency, and clarity, and enshrines the principle that regulation should be effective, proportional, and closely geared to risk.
The Financial Services and Markets Act created a 21st century regulatory regime. To reduce the complexity of our regulatory structure we have reorganised the existing regulators into a single body: the Financial Services Authority. We now have a single regulator, and a single, consistent body of regulation for the whole financial services sector. The aim is a transparent and coherent system, with regulation flowing from a single source.
The investment banking industry has a corporate interest in ensuring the success of the new regulatory regime. It is an open system, with the FSA required by the Act to consult when it makes rules, and to publish cost benefit analysis - I would encourage you all to engage with the process.
Effective and efficient regulation will be one of the key factors in upholding the reputation of the UK as a financial centre. In recent years there have been many investigations and enquiries into various failings of the industry. I make no apology for that.
We are taking the steps that are necessary to uphold the integrity and protect the reputation of the UK financial services industry. Many of the scandals have centred on the insurance industry, but investment banking has not emerged unscathed.
A zero failure regime is not a desirable option. Some failures are inevitable, in any system, if we are to adequately promote enterprise, innovation and risk-taking. Of course that is not an excuse for inaction. We must remain vigilant, and where specific problems do arise, we must work together to find a solution.
One such problem, currently topical, is the perceived conflicts of interest between research analysts and their investment banking colleagues.
Chinese walls have been established between the two, but the collapse of Enron has brought the shortcomings of this system sharply into focus and created a demand by some that something be done to address the problem.
There have been varying reactions across the financial world. France and Germany had already planned legislation to force banks into much greater disclosure and to sever the link between analysts? pay and the success of the deals they have researched. The public reaction in the US has been more vigorous, with members of Congress and the New York State Attorney-General demanding strong measures, though the SEC has, thus far, been more moderate in its specific proposals.
Here in the UK, regulatory responsibility lies with the FSA. Rules and guidance covering relations between researchers and their investment colleagues already exist, and the FSA is revisiting these to decide whether they are sufficiently robust to deal with the current challenges. Regulation is only part of the answer: market forces, exerting an influence through actual or perceived loss of reputation, have already triggered changes of practice to satisfy customers? concerns.
It is in all of our interests to resolve the problems, retain confidence in the integrity of integrated investment banks, and enable industry and investors to move forward with confidence.
Integrated investment banks - combining corporate finance and equity functions - are a relatively recent phenomenon. They are the product of deregulation ?of course - but also of increasingly connected world markets and the economies of scale that they generate.
In world markets, where capital flows at the touch of a button and daily transfers in the foreign exchange markets dwarf national GDPs, concern with foreign ownership can seem anachronistic. Of course there were advantages to the old school and the closed shop of the past - many of them accruing to the small group of privileged insiders - but the whilst some may even remember it with fondness we should not mourn its passing.
Return on capital in the UK banking industry is now the highest in the world at 26%. The contribution of the banking industry to GDP has grown enormously over the past decade now standing at 3.6%. And the number of people employed by the industry has increased to 445,000. There have been deeper cultural changes - the City is now more meritocratic, more women are employed - many of them occupying prestigious positions, cases of racism and sexism have emerged into the public eye and that openness to scrutiny is to be welcomed - that is how progress is made. I think it no coincidence that the most meritocratic, the most open and diverse, areas of the City have proved the most successful. Just look at the City's dominance of international bond markets.
So the emergence of foreign banks as some of the most important players has signalled not just an economic but also a cultural change - and of course the two are linked and a more meritocratic City will also be a more productive City. I would argue that the presence of a large number of foreign banks in the UK and the significant amount of lending to overseas customers is a clear indicator of London's leading role as an international centre - a source of strength.
We are open and we are also fair. That means equal treatment from the regulator for foreign banks. It also means fair taxation of foreign company branches. The Budget contained measures to ensure that foreign company branches pay a fairer share of UK corporation tax - taking us into line with best international practice.
Embracing institutions from overseas is part of the tradition of the City. So too is lending to overseas customers. The UK is the largest single market for the cross border banking business with nearly 20% of international bank lending in September 2001.
Operating in other markets means dealing with other systems of regulation and different approaches to investment banking. It is in all of our interests to ensure that this process is managed smoothly.
In the EU that means:
- Focusing on mutual recognition of core standards and greater regulatory co-operation;
- Designing legislation to manage risk - not avoid it;
- Prioritising measures in the Financial Services Action Plan; and,
- Producing legislation that is proportionate, flexible and responsive to market developments.
The Lamfalussy report provides the framework for the reform of the EU's securities markets. Prioritising directives that would bring the biggest economic benefits, emphasising consultation and transparency in the drafting of legislation, and arrangements to speed up the passage of directives, can only enhance the integration of the EU's securities markets and improve conditions for the UK financial services industry.
Now the Commission and the European Parliament have overcome their differences regarding secondary - "comitology" - legislation, we need to move swiftly to capture the benefits of the Lamfalussy approach.
Successful implementation of the Lamfalussy recommendations should mean that work on future EU securities directives moves more smoothly.
The Commission's consultation on the Investment Services Directive is a good start. We welcome this process as a sign of increasing openness in the development of legislation, and hope the Industry will use the opportunity to provide constructive input at an early stage.
The work does not stop there. The EU's work on financial services is hampered by a confusing mass of committees dealing with banking and other financial services. This is not merely a bureaucratic problem. It hinders progress towards a dynamic single market. It reduces national and European authorities? ability to look at financial stability issues collectively. Without reform, European finance ministers do not have the right tools to create a dynamic single market in financial services and to be vigilant for possible threats to Europe's financial stability.
Gordon Brown and Hans Eichel are determined to ensure that ministers have these tools. That is why they recently launched an initiative, which has now been taken up by European finance ministers collectively. Finance ministers will receive a first report from officials in July, with final decisions scheduled for the autumn.
This is an important project. It will strengthen the accountability chain from the EU's financial sector work through Europe's finance ministers to businesses and citizens. It will help the Treasury act effectively as ?intelligent sponsor? of the industry. And it will help deliver the dynamic and stable single market in financial services that is vital to Europe's economy.
The interests of the EU and the interests of the UK financial services industry are, ultimately, closely aligned. We have only to consider the role of the City in creating deep and liquid markets in the Euro to recognise the importance of the link.
There can be little doubt that the UK financial services industry is maintaining its competitive position, and continuing to contribute substantially to the UK economy, despite our position outside the Euro. But there is no room for complacency and we are right to regard engagement with the EU, and the existence of the Euro, as an opportunity for your organisations to develop and grow.
And we are right to include the impact on financial services as one of the five tests for UK membership of EMU, the assessment of which will be completed within two years of the start of this Parliament. We are right because the financial services industry in general and the investment banks in particular play an important part in the development of the UK economy. It is in all of our interests to see an effectively functioning investment banking industry, allocating investment efficiently, and driving higher levels of growth across the wider economy.
London's future as a centre for investment banking rests on the development of these strengths. Building on a tradition of open, competitive markets we can secure London's position as a world leader in investment banking, with the industry productive in itself, and driving productivity across the rest of the economy. Dialogue is the way forward, we always want to understand the industry better, so I will be interested to hear your views.