The Future of European Financial Centres

The Future of European Financial Centres

At present London is the only truly global financial centre in Europe. Does this necessarily imply that it must become the main European financial centre or are there powerful factors working in favour of a continental financial centre? Does the future belong with Frankfurt? This volume examines the future of European financial centres in the context of economic and monetary union (EMU). Based on substantial original empirical research, it investigates the relative competitiveness of European financial centres, with special reference to London and Frankfurt, using a variety of analytical techniques from location theory to game theory. Issues covered include: • • • •

the evolution of financial centres optimal design of an international financial centre EU and international financial services regulation the competitiveness of world financial centres

The Future of European Financial Centres will be of interest to students of and researchers in European finance and European economics. Kirsten Bindemann is a Research Fellow at the Oxford Institute for Energy Studies, having previously lectured in economics at the Free University, Berlin and the University of Bristol.

Routledge International Studies in Money and Banking

1 Private Banking in Europe Lyn Bicker 2 Bank Deregulation and Monetary Order George Selgin 3 Money in Islam A study in Islamic political economy Masudul Alam Choudhury 4 The Future of European Financial Centres Kirsten Bindemann 5 Payment Systems in Global Perspective Maxwell J. Fry, Isaak Kilato, Sandra Roger, Krzysztof Senderowicz, David Sheppard, Francisco Solis and John Trundle

The Future of European Financial Centres

Kirsten Bindemann

London and New York

First published 1999 by Routledge 11 New Fetter Lane, London EC4P 4EE Simultaneously published in the USA and Canada by Routledge 29 West 35th Street, New York, NY 10001 Routledge is an imprint of the Taylor & Francis Group This edition published in the Taylor & Francis e-Library, 2001. © 1999 Kirsten Bindemann All rights reserved. No part of this book may be reprinted or reproduced or utilised in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging-in-Publication Data Bindemann, Kirsten, 1966– The future of European financial centres / Kirsten Bindemann. p. cm. Includes bibliographical references. 1. Financial services industry–European Union countries. 2. Financial institutions– European Union countries. 3. International finance. I. Title. HG186.E8B56 1999 99-20645 332.1´094–DC21 CIP ISBN 0-415-20403-8 (Print Edition) ISBN 0-203-02370-6 Master e-book ISBN ISBN 0-203-17227-2 (Glassbook Format)

Contents

List of tables List of figures List of abbreviations Acknowledgements

vii viii ix xi

1

Introduction

1

2

The emergence of financial centres

4

3

4

5

A general survey The emergence of London and Frankfurt Implications for future developments Appendix 2.1: Motives for EU alliances Appendix 2.2: Economic Darwinism

4 12 17 20 20

On the optimal design of an international financial centre

24

Three studies on financial centres The findings An analysis Appendix 3.1: Desirability bias

24 28 40 47

The rules of the game: Regulation of financial services

49

An overview A blueprint for Europe’s financial markets Some issues

49 55 61

A game theory approach to financial centres

69

Some theory An application: London and Frankfurt

69 76

vi

6

7

Contents An extension: Frankfurt and Paris versus London Appendix 5.1: Further evidence

87 90

Conclusions: Some implications for London and Frankfurt

91

A summary A European and an international financial centre Geography still matters

91 93 95

Epilogue: Recent developments

97

Stock exchanges Derivatives The impact of EMU

97 99 101

Literature

106

Appendices

114

A The 1996 Survey B Other surveys C The 1996 survey: Results

114 136 139

Index

150

Tables

2.1 2.2 2.3 2.4 3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8A 3.8B 3.9 3.10 3.11 3.12 3.13 3.14 4.1 5.1 5.2 5.3 5.4 5.5

Location choices Central banks and financial centers Motives for EU alliances (by industry) Evolutionary mechanisms Headquarters of institutions Statistics of institutions The most important criteria The less important criteria Overall ranking of criteria Reasons for London’s leadership A comparison of tables 3.5 and 3.6 Scores for main centers Scores for medium sized centers Comparative ratings Ranking by unweighted placings London views on Frankfurt and Paris The strengths of London The most important criteria for financial centers Comparative ranking The main EC/EU directives/activities in financial services Key activities of the London and Frankfurt Stock Exchanges (1995) Advantages and disadvantages of London and Frankfurt Stock exchange listings and turnover (1997) Turnover at derivatives exchanges (number of traded contracts) Foreign shares quoted at FWB

7 11 21 23 26 27 29 29 29 32 33 35 35 37 37 39 39 41 42 56 81 82 90 90 90

Figures

3.1 5.1 5.2 5.3 5.4 5.5 5.6 5.7

Framework for a successful financial center Challenger’s first decision Incumbent’s reaction Challenger’s second decision Two types of incumbent Expected utilities Volume on stock exchanges in DM bn (1994/1995) Volume on derivatives exchanges: Contracts traded in 1,000s (1994/1995) 5.8 Domestic and foreign turnover value in £ bn (1995) 5.9 Listed domestic and foreign companies (end 1995) 5.10 Signals and responses 7.1 The Eurex network 7.2 Frankfurt’s network

46 71 71 71 72 76 78 78 79 79 85 104 104

Abbreviations

AIM BCCI BdP BIS BMF CAD CBOT CME COM COPS CREST DAX DM DTB EC ECB ECU EEC EMU EU Eurex FWB GDP IBIS IFC IfK IMF IOSCO ISD IT LIFFE LSE MATIF

Alternative Investment Market Bank of Credit and Commerce International Bourse de Paris Bank for International Settlements Bundesministerium der Finanzen Capital Adequacy Directive Chicago Board of Trade Chicago Mercantile Exchange Commission of the European Communities Centre d’Observation et de Prospection Sociale CRESTCo’s share dealing settlement at the LSE Deutscher Aktienindex Deutschmark Deutsche Terminbörse European Community European Central Bank European Currency Unit European Economic Community Economic and Monetary Union European Union European Exchange Organization Frankfurter Wertpapier Börse Gross Domestic Product Integrated Stock Exchange Trading and Information System International Financial Centre Institut für Kapitalmarktforschung International Monetary Fund International Organisation of Securities Commissions Investment Services Directive Information Technology London International Financial Futures Exchange London Stock Exchange Marché à Terme International de France

x

List of abbreviations

MONEP N/A NASDAQ NYSE OECD OJ OPEC ÖTB OTC PIPE R&D SBD SEA SEAQ SETS SFA SIB SOFFEX STOXX TALISMAN TAURUS TRADEUS UCITS US USA USM UK XETRA

Marché des Options Negotiables de Paris not applicable National Association of Securities Dealers Automated Quotation New York Stock Exchange Organisation for Economic Cooperation and Development Official Journal Organisation of the Petroleum Exporting Countries Österreichische Terminbörse (Austrian Derivatives Exchange) Over-the-Counter Price and Information Project for Europe Research and Development Second Banking Directive Single European Act Stock Exchange Automated Quotation Stock Exchange Electronic Trading System Securities and Futures Association Securities and Investment Board Swiss Options and Financial Futures Exchange Group of Stock Indices traded on Xetra Transfer Accounting Lodgement for Investors and Stock Management for Principals Transfer and Automated Registration of Uncertified Stock Electronic trading system jointly operated by DTB and Matif Undertakings for Collective Investment in Transferable Securities United States Unites States of America Unlisted Securities Market United Kingdom Exchange Electronic Trading

Acknowledgements

I should like to thank Michael Bolle and David Webb for getting me first interested in economics and financial markets respectively. I am not sure whether they knew what they were letting themselves in for. Credit is due to Michael Allingham who shaped my thinking in more than just an economic way. I very much appreciate the efforts of a large number of people who were very generous with their time in completing the questionnaire, making themselves available for interviews, and forwarding any additional information. Particular thanks go to Didier Davydoff at Bourse de Paris whose insistence that I got it all wrong made this, I hope, a better paper. I also wish to thank the DAAD for financing the first year of this research. Special thanks are due to Albert, Efi, Karen, Maija, Maria and Taiichiro for their friendship, and to David Demery and Nigel Duck at Bristol for many stimulating discussions about life in general. The thesis is, however, dedicated to my mother. She knows why. The usual disclaimer applies.

1 Introduction

Within the context of the single market, Europe will not only become an area of common law but also of homogeneous financial institutions, and finally a single currency. Economic theory suggests that a single European financial market will tend to set up a main financial centre. This also corresponds to historical experience. If it is true that the efficiency of markets increases with their diversity and their competitiveness, then this is mainly fostered by central markets. From this we can conjecture that the tendency to higher efficiency is thus at the same time a tendency to centralisation. Since it is easier to conduct business of any kind and size in a large market that offers the whole array of services, it will be superior to a smaller one. At present London leads by a wide margin as financial centre in Europe. Indeed it is the only international financial centre in this part of the world. This is not due to a specific European function but to its role as one of the three global financial centres alongside New York and Tokyo. However, this does not necessarily imply that London must become the main European financial centre. Factors like its peripheral location, the Euro-phobic attitudes of policy makers, the refusal to join Economic Monetary Union (EMU) and adopt the single currency, as well as the intercontinental orientation of London are in favour of a continental European financial centre, namely Frankfurt. The rationale for concentrating on these two locations is that London is the leading financial centre in Europe while Frankfurt, as a fast developing financial place of the largest European economy, is its main continental rival. The realisation of the single market will eliminate problems like national currencies or differing regulatory standards since the free movement of capital, freedom of services, as well as legal harmonisation will be the same for all European Union (EU) member states. Thus, by competing to become the future European financial centre, the specific characteristics of financial places will be increasingly important. This holds for the organisation and efficiency of markets in the same way as for economic and political stability, tax systems, the state of deregulation, infrastructure, communication facilities, qualified personnel, and the cultural environment.

2

The future of European financial centres

Starting from the premise that London is the only international financial centre in Europe, we will argue that Frankfurt seems to be the obvious choice for the main European centre and that its overall position is not threatened by Paris and the latter’s more aggressive efforts to get its financial centre into shape for international competition. We will also show that although at least for the near future neither city poses a serious all-round challenge to London it would be fatal for London to be complacent. We propose to shed some light on a series of questions. Why is London the leading financial centre in Europe? How have financial centres historically emerged, and is London’s position an affirmation of history or is its leadership based on other factors? What is the best strategy for Frankfurt to further its cause, and does it have a chance to seriously rival London? Will the EU regulatory framework benefit the former at the expense of the latter? Chapter 2 gives an overview of the way financial centres emerged historically. Special attention is paid to the developments of London and Frankfurt, and the question about the supremacy of the former. However, we will also analyse other locations, some of which have been world centres in the past, such as Amsterdam, and others which aspire to become global players, such as Paris. Having thus shown how a location can become a financial centre, and in particular an international financial centre, we then attempt to formulate the optimal design for a financial centre. We will compare the results from our own questionnaire survey to those of earlier comparative studies. The surveys cover the period 1986 to 1996, therefore accounting for views on financial centres pre and post single market legislation. The linchpin is our own 1996 survey which asked the opinions of those working for commercial and central banks, governments, stock and derivatives exchanges, and financial consultancies as well as academics, financial journalists, and other researchers. The questionnaires examine issues such as the most important criteria for a financial centre to succeed at the international level, the locations that best fulfil these criteria, areas in which weaker sites have to improve in order to be competitive, government strategies, and the impact of EU regulation.1 After having investigated financial centres historically, via a location theory approach, and with regard to the optimal design of an international financial centre, we next turn to the matter of financial services regulation. We will outline the compatibility of European and international regulation as well as the objectives and forms of regulation. Here it will be shown how EU regulation affects different European financial centres and whether the single market might be an advantage for the campaigns of Frankfurt and Paris in particular. We next introduce a game theory approach to financial centres. This chapter is designed to present some ideas about the strategies financial centres can adopt in their quest to become a leading player or, as in the case of London, to stay ahead of their competitors. The concept is first applied to London and Frankfurt, and then extended to cooperation between Frankfurt and Paris.

Introduction

3

Finally, in the conclusion we will illustrate the implications of our analysis for London and Frankfurt. Taking up our initial hypothesis that London is an international financial centre whereas Frankfurt is a European centre, we will highlight the differences between the two categories, and compare the global competitiveness of the two locations. The focus will be on the question of why at present London is an international player and why Frankfurt is lacking behind. This will lead us to the discussion of whether there will be one main financial centre in Europe with other places specialising in certain activities, and in how far Europe can succeed at an international level particularly in competition with New York and Tokyo.

Note 1. One aspect not covered in this book is that of taxes. This is due to two reasons. First, and most importantly, the results of our 1996 empirical survey show that tax treatment is of inferior relevance in the context of this topic. Second, taxation is such a big area that any in-depth research would merit a book in its own right.

2 The emergence of financial centres

Research on locational competition shows that there is no single dominant determinant or even combination of factors1. The question therefore arises whether size and direction of asset mobility is a result of locational competition or whether other forces are at work. In this chapter we analyse the emergence of financial centres with special regard to London and Frankfurt. If we accept the conclusion from the previous chapter that the former is an international financial centre while the latter is a European one the question arises about the events and factors that allowed London to overtake Amsterdam, outperform Paris and play a predominant role in the international financial world. We consider the basis for shifts in dominant financial centres, and discuss whether financial history might repeat itself and thus enable Frankfurt to create the environment necessary to surpass London.

A general survey Current conceptions of the relative strengths of various financial centres have been shaped by many events. We first consider the facts, that is how London reached the pinnacle of the world’s financial markets. This historical overview is then contrasted with some economic theory. The location theory approach illuminates how economists expect one location to gain superiority over others. This will help us to explain whether London achieved its position in the ‘conventional’ way advocated by the theory or whether other factors played a role in its development. Some such determinants that go beyond location theory are discussed in the remainder of this section.

The historical perspective Lees and Eng (1975) trace financial market activities back to 1900 BC and the Babylonian temples. Via the Athens forum (500 to 300 BC) they arrive at the Roman Empire concluding that ‘the Romans were pioneers of financial market regulation within a comprehensive legal framework’ (Lees and Eng 1975: 4). They then observe

The emergence of financial centres

5

a step backwards during the feudal systems before the revival of financial centres in Europe after the Magna Charta in England (1215) and particularly after the Industrial Revolution. ‘On the eve of the Industrial Revolution, Europe had developed the roots of the international financial markets’ (Lees and Eng 1975: 5). The foundation for British financial leadership was laid in the 17th century, and in the 19th century London became the world’s leading financial centre with Amsterdam, Berlin, Milan, Paris and New York being the other main players. Financial activities during this period were based on two pillars, the gold standard and accelerating industrial development. At the same time there existed only a relatively small number of international financial institutions. The prevailing free enterprise spirit often subjected financial markets to the influence of individuals or individual institutions like the Rothschilds in Europe and J. P. Morgan in the USA. Various factors connected with the outbreak of World War I led to New York becoming the leading financial centre. Sterling was weakening and the USA established a strong export position and consecutively tremendous capital market facilities with the dollar as the only major currency still convertible into gold. Lees and Eng (1975) see the inexperience of the USA as world financial centre as one of the variables that triggered the stock market crash in 1929, a theory it is beyond the scope of this paper to discuss. However, it followed a period with virtually no international financial markets; the gold standard was abandoned and international trade and foreign exchange were heavily restricted. After World War II the emergence of Bretton Woods with the International Monetary Fund (IMF) and the World Bank, as well as more than a decade later the establishment of the European Common Market, led to a revival of international financial activities. In addition the number of new financial centres increased mainly due to developments in Asia, Africa and Latin America in the 1960s. Generally speaking, the intensification of competition for goods, capital and technology on an international scale accounted for the unprecedented growth of international financial markets. The Interest Equalisation Tax after 1963 on foreign security purchases by residents of the USA plus higher interest rates in Europe made foreign investors turn to the more deregulated European markets. The growing eurodollar market, market opportunities and lower labour costs attracted US investment firms so that there was a far greater demand for capital in Europe. Not only corporations but also governments required financial market facilities world-wide. This in turn strengthened the position of international banks in providing liquidity. In this context Kindleberger (1978) points out that external economies of scale, leading to self-sustaining growth, are a major factor underlying the development of a financial centre. He observes that companies of a certain size have a tendency to establish offices in the ‘metropolis’ (Kindleberger 1978: 72). In his view economies of scale favour centralisation, therefore the reduction in cost and an improvement in transport and communications during the past two centuries suggest the formation of one world financial market. This brings us to the issue of geographical patterns in the development of financial centres. ‘Cities are typically located at a break in transport. Such a break must lie across a trade route’ (Kindleberger 1978: 73). London and Paris for instance

6

The future of European financial centres

lie on major rivers, while Berlin is located at the point of transhipment for cargoes from the Oder to the Elbe. In the 19th century the advance of the railroad system changed the character of the location of some financial centres.

A location theory approach Industrial location theory discerns several principal factors which affect the optimal choice of a location. We only give a very concise summary of the theory that should enable us to set up a framework for further analysis of the emergence of certain locations as financial centres. A more detailed, and at times more technical, account of location theory can be found e.g. in Beckmann (1968), Devine et al (1979), Hamilton (1974), Richardson (1978) and Townroe (1971). First of all there are considerations regarding supply, that is the availability of factor inputs such as labour, materials, and technology, but also the right of establishment as well as appropriate premises, and demand for a product or service. The latter places an emphasis on the access to customers. A further aspect is the initial investment required. These sunk costs comprise training and movement of employees, building or acquiring premises, application fees for licences, and in case of a change in location the potential loss of customers. This last point, the change of location as opposed to a complete new establishment, is of particular relevance regarding those factors of production that are not transferable e.g. buildings or land. Firms consider internal as well as external economies of scale when choosing a location. Internal economies relate to the decision whether a firm establishes one large unit or rather several smaller ones at different locations. External economies on the other hand are concerned with the size of the industrial sector. Once a certain size is reached the location will attract other, related, industries or services, thus making it easier and cheaper to obtain production factors. In this context, Davis (1990: 3) also points out the possibility of diseconomies. Larger firms may become too difficult to manage, and external economies can lead to transport congestion and other negative feedbacks thereby increasing transport costs. Transport costs are another factor on which location theory focuses. It is linked to both the costs of obtaining production factors, and the costs of distributing the product. Finally, there is a set of issues that are closely interlinked: shocks, psychological factors, information, and uncertainty. If a large number of competing or supporting businesses leave a location, a firm may feel under pressure to investigate other locations. The decision which locations will be surveyed may be based on the perception of certain places e.g. the trendiness of a site. When researching the suitability of a location, access and reliability of information are crucial. A firm will not only want to know about the location itself but also about possible strategies of its competitors. In the case of a multinational company factors such as political and economic stability, the state of regulation, and the prevailing tax system will all be looked upon. It should also be mentioned that some empirical studies (e.g. Townroe 1971) found that firms’ location decisions are not necessarily systematic and that often only very few locations are investigated.

The emergence of financial centres

7

In summary, location theory mainly explores the aspects of supply, demand, sunk costs, internal and external economies of scale as well as diseconomies, transport costs, psychological factors, and the problems of information and uncertainty. To put it differently, the decision for or against a location depends on costs and rewards whereby the latter usually refers to revenues2. The availability of inputs such as labour or materials, and access to markets often reduce choices to a few feasible locations. Table 2.1 distinguishes the four main scenarios. Let’s start with the bottom row. A market-based decision occurs when production costs are the same at all potential locations but the transport of the product is costly because consumers are dispersed. Thus, the firm will locate its production where demand is greatest. In the flexible scenario all product and factor prices are uniform. This can mean one of two things. The firm is either a service provider and requires no material resources, or said inputs have constant prices at all locations. A decision is dictated by inputs when the price and/or availability of the latter varies with location but the firm can sell its product at the same price at any location. Finally, if both demand and inputs are geographically determined (location specific) ‘profit maximization reduces to cost minimization, and cost minimization in turn reduces to the minimization of transportation costs’ (Beckmann 1968: 125). With regard to Table 2.1 we would expect financial centres to move increasingly towards the bottom-right scenario. The rise of globally used information technology (IT) enables market participants to deal from any location with any location. However, regardless of the validity of this insight we shall see later that this will not necessarily lead to the flexible case. So let’s now examine one element at a time. On the supply side, factors which matter for financial institutions are personnel, licence fees, availability and cost of premises, and technology. Financial services are labour intensive. Personnel should ideally be well educated and qualified. In contrast to e.g. manufacturing where usually new plants have to be built, financial institutions can often take advantage of existing office space. Technology in this context is mainly related to access to screen-trading and the linking of markets. In a physical sense it might be argued that communications equipment, e.g. computers, has more or less the same cost regardless of the chosen site. Furthermore, financial firms are concerned with the availability of funds, the cost of funds, and regulatory issues such as reserve requirements. When investigating a location they will compare different tax systems, focusing on corporate and withholding tax as well as stamp duties, and payments and settlements systems. Financial institutions can also be expected to analyse carefully any restrictions that might exist regarding the scope Table 2.1 Location choices Gains Location specific

Location unspecific

Location specific

Max/min

Input based

Location unspecific

Market based

Flexible

Costs

8

The future of European financial centres

of their activities, general government influence, and consumer protection schemes which may affect their costs. The main point on the demand side is the access to customers. When transferring this point from general location theory to the financial services industry it is essential to distinguish between retail and wholesale customers. Traditionally, as we have argued above in the case of euromarkets, banks follow their corporate customers abroad. The latter then prefer to bank with their old, tried banks. Trust and confidence are therefore crucial elements. Nowadays the trend is, as e.g. Thießen (1988) observes, that the distance between client and bank becomes larger rather than shorter. This view is supported by the steady growth of offshore centres. Thus, in the wholesale sector customer accessibility is not necessarily a prime influence any longer. However, for retail intermediaries physical presence is still a vital aspect. Davis (1990: 6) rightly points out the ‘continuing importance of branch networks’. Now consider sunk costs. The initial expenditure for a financial institution might be considerably less than for a manufacturer, since the former can usually fall back on existing buildings at the new location, and sell their old premises that might have been leased anyway. Nonetheless, costs are involved on a large scale when it comes to recruiting and training new employees, moving existing staff, obtaining licences, compensating for a potential loss of clients, and building relationships with other financial firms. Extra costs may arise in the form of additional reserve requirements when moving across borders. We should also distinguish between firms that have to establish themselves newly at a certain location and those that are already represented through branches. If the latter is the case some start-up costs such as membership fees might be omitted. Internal economies can be gained from the centralisation of different parts of the business like dealers, speculators and analysts. Up to this point we can state that financial institutions are not quite as location specific as other firms. This picture, however, changes when we move on to the issue of external economies of scale. As soon as a location develops into a centre, here a financial centre, the phenomenon of self-sustaining growth can be observed. The more financial institutions settle at a location the more supporting or otherwise related services will follow. Apart from firms directly concerned with financial investment we will find lawyers, accountants, messenger services, public relations firms and computing services to name just a few. A body of expertise builds up over time, and trusting business relationships are established. This might well stem from the close proximity of traders and lawyers, accountants etc. In this context it should be stressed that primary issuing trading possibly requires greater need for personal contact and well-established relationships than secondary trading. There will also be joint services like clearing houses, research institutes and clubs. The latter should not be underestimated. As we will discuss later, the power of social networking and rumours plays an important part in the financial services industry. All this should be seen in the context of information. Agglomeration may cause a faster, more reliable information flow and hence lead to

The emergence of financial centres

9

more efficient prices. Arguably, the kind of centralisation we just discussed can create diseconomies as well e.g. traffic congestion with all its consequences. Transport costs arise for financial services e.g. in the form of telecommunication rates that might differ between locations. As for the set of shocks, psychological factors, information, and uncertainty, what we pointed out for industry in general also holds for financial services. From the discourse so far we can derive that external economies of scale are the most important factor for the development of a financial centre. This view is supported by Krugman: the role of some cities as centres of international intermediation [...] may represent a combination of comparative advantage and economies of scale. Most notably, London acts as a world financial centre partly because of the external economies associated with its already established position (which in turn rests on historical accident). (Krugman, 1987: 13) Empirical research indicates that locational competition is linked to the nature, size and direction of asset movements (Commission of the European Communities [COM] 1991). Pelkmans (1997) points out that advances in the integration of the EU market for financial services have led to a change in the nature of asset mobility. This applies in particular to non-EU firms which have shown a keen interest to establish themselves in EU countries. This trend has, in turn, intensified competition between EU locations. Pelkmans lists elements such as human capital, infrastructure and the general framework for business operations as being decisive influences. A Commission survey (COM 1991) yields the result that 25 percent of the companies captured in the study have chosen directly between competing locations rather than first selecting a country in which to base their activities. This, says Pelkmans, supports the thesis that locational competition has an impact on the direction of asset mobility. Although it is difficult to assess how the size of asset flows is affected by different locational characteristics there are signs that mobile assets cluster regionally. Pelkmans thus concludes that: The greater the mobility of tangible assets of companies, the greater the importance of locational factors of regions and countries. Since national policies to boost locational advantages are restrained by intra-EC liberalisation [...], greater factor market integration induces fierce competition among regions in the EU to attract mobile, tangible assets such as [...] distribution centres, services providers [...] or indeed head-offices of multinationals. This locational competition is driven by natural advantages, agglomeration effects [...], specific forms of sourcing but also by policy competition. (Pelkmans, 1997: 161)

10

The future of European financial centres

Other determinants Besides these elements that are related to industrial location theory there is another set of factors which in the past have led to the formation of financial centres. Some of these have already been outlined, others will emerge again in the next section. Therefore, we will only draw a brief sketch at this point.

Currency A strong currency may (though we are not convinced) be important for a European centre, but it is not for an international centre: London is one of the leading financial centres which transacts most of its business in dollars (see also Chapter 1). Having said that, the psychological impact of the (perceived) strength of a currency should not be underestimated. A strong currency might be regarded as the symbol of a strong, healthy and reliable economy. This in turn might be read as a signal that investments in that economy’s financial sector are safe and therefore desirable.

Central bank/administrative capital The question is whether the location of the central bank might have an effect on the ultimate choice by the market of a physical centre. Taking this one step further we have to ask whether the location of the future European central bank will influence the choice in favour of a particular centre, a point we will take up again in Chapter 5. Table 2.2 shows that generally the financial centre was founded earlier than the central bank. Most central banks are located in the capital of their country. In most countries the central bank and financial centre are located in the same city. On the other hand the issue arises why in some countries the money and capital markets are located in the administrative capital of that country (e.g. France and the UK) while in others they are not (e.g. the USA, Canada, Germany, Switzerland). Central banks have strong ties with the rest of the banking system. Thus, banks may wish to be located at the same site as the central bank. This would explain the case of financial centres and central banks being at the same location. The central bank is also the government’s bank and may therefore prefer to be close to the political centre (capital). Most countries that have their central bank and financial centre in their administrative capital are also operating very centralised political systems e.g. Belgium, France, Japan and the UK, while those with different locations rely upon more federalist structures such as Germany and the USA.

Tradition According to our analysis in the first section of this chapter, tradition would favour London over Frankfurt. But, as Kindleberger (1978) suggests, this is not enough to ensure leadership as a financial centre. He stresses that history proves that savings

The emergence of financial centres

11

Table 2.2 Central banks and financial centres Country

Central bank

Financial centre1

Australia Belgium Canada Denmark France Germany2 Greece Ireland Italy Japan Luxembourg3 Netherlands Portugal Spain Sweden Switzerland UK USA

Canberra (1959) Brussels (1850) Ottawa (1935) Copenhagen (1936) Paris (1800) Frankfurt (1957) Athens (1928) Dublin (1943) Rome (1893) Tokyo (1882) N/A Amsterdam (1814) Lisbon (1846) Madrid (1922) Stockholm (1897) Bern (1906) 4 London (1694) Washington (1914)

Sydney Brussels (1801) Toronto Copenhagen (19th century) Paris (1724/1801) Frankfurt (1896/1948) Athens (1876) Dublin (1799) Milan Tokyo Luxembourg (1929) Amsterdam (1611) Lisbon (1901) Madrid (1831) Stockholm (1863) Zürich (1877) London (1773) New York (1817)

1. The year of foundation is usually the year when the stock exchange started its work. Where a country has more than one financial centre, we mean the most important of those. It was not always possisble to trace the first mentioning of a location as a financial centre; sometimes not even the stock exchanges were in a position to clarify this question. 2. Prior to Bundesbank: Reichsbank (Berlin) 1875; Bank Deutscher Länder (Frankfurt) 1948. 3. Monetary union with Belgium in 1944; Institut Monetaire Luxembourgeois performs some central bank functions. 4. Central bank headquarters in Bern, governing board in Zürich.

are also necessary to enable dealers to make a market, meet borrowing requirements and sell out of an inventory when the rest of the market is buying. In this context it can be argued, as indeed Kindleberger does, that London’s early success in the eurocurrency market stemmed from the presence of large US banks which provided savings and hence much needed liquidity. Nonetheless, as we have shown earlier, there is still a desire for face-to-face business, and long-established relationships. Therefore, existing market participants may want to stay where they are.

Central location Central location means a location that is geographically central. This would rule against peripheral locations such as London, and in a way also against Amsterdam, but favour cities like Frankfurt or Paris. However, the relevance of this point can be refuted on several grounds. First, history shows that geography was no disadvantage for either Amsterdam or London. Second, the continuing advance in technology makes travelling widely unnecessary but at the same time also faster. Faxes, phones and computers have frequently taken the place of ‘human

12

The future of European financial centres

dispatchers’. Third, most modern financial centres are easily accessible. They host international airports and well developed rail links. One remaining issue is that of being located in a time zone. If we concentrate on London and Frankfurt, the time difference is one hour. This is hardly significant enough to put one of the two at an advantage. In addition the advance of after-hour as well as 24-hour trading makes the problem of time zones almost futile.

Culture Differences in culture and language can create difficulties regarding market access. Many corporations have had that experience when trying to penetrate the Japanese market. However, European cultures are not so different as to cause cultural shocks of any kind. Since English is the dominant language in international finance, communication problems at business level are almost non-existent. We will come back to this point, as indeed to most other issues raised here, when we develop the optimal design for a financial centre (Chapter 3).

Policy A final issue to be examined in this context is whether government policies can determine the success of a financial centre and turn it into an international centre, or whether governmental influence merely accelerates or slows down the process of becoming a financial centre. This point, too, will be analysed in later chapters. However, the empirical findings of the Commission’s survey (COM 1991) and the discussion in Pelkmans (1997) appear to indicate that policy can indeed have a crucial impact. Furthermore, Kindleberger (1978: 133) emphasises that historical evidence suggests that the shift to a new financial centre is usually preceded by a significant increase in take-overs and mergers. If we transfer this observation to the present situation a quick scan of the business press during the last few years suggests that there is bustling activity in this area. In fact between 1986 and 1990 the intra-EC share of cross-border mergers and acquisitions increased from 25 percent to 65 percent with only a slight reduction to 60 percent in 1992 (COM 1993). In essence, financial centres historically emerged after wars, through technological developments, on the basis of a most favoured currency, and as a reaction to regulation. Further determinants of location are pure accident, and a kind of Darwinism3 that sees badly placed or incautious financial institutions close down during a depression. If this happens on a large enough scale it might cause the establishment of a new location as financial centre.

The emergence of London and Frankfurt In this section the focus is on London and Frankfurt and how they became major financial centres. However, we also give a short survey of the history of some other financial places.

The emergence of financial centres

13

London The leitmotif which runs through the City’s evolution into a world financial centre is the unique relationship with the state. Ever since the Middle Ages, London’s merchants were given monopoly trading rights on the basis that they raised funds for the state. This way a series of trade wars could be financed which were the cornerstone for a financial empire centred on the Square Mile. The monarch granted privileges to chartered corporations as early as the 15th century, thus fostering the centralisation of financial services and the City’s increasing dominance of the economic life in the country. In the 17th century, despite the fact that in addition to its strong financial position London hosted one of the great trading ports, it was Amsterdam which was the trend-setter for financial innovation. Both the first stock exchange and the first national bank were founded in Amsterdam. These early developments helped the Dutch to meet the requirements of a fast-growing commercial empire. Amsterdam can be regarded as the first trading city for public loans. We will take up this point later on when discussing some other financial centres. Several factors have to be taken into account in order to answer the question of how London was able first to rival and then to eclipse Amsterdam, and how the City emerged as a world financial centre. The first regularly printed stock price list was published in London on 4 July 1681 (Neal 1990: 21). According to Neal (1990: 27) the first evidence for official price listing for the Amsterdam stock exchange can be dated August 1796. These findings allow us to conclude that a major factor in becoming the predominant centre is the monopolising of commercial information. As already mentioned the City thrived on the strong partnership with the Crown. The Bank of England, which was established in London in 1694, fitted neatly into this scenario. The Bank was given nearmonopoly of the issue of banknotes, and provided the funds for the Nine Years War with France. Afterwards it took over the responsibility for marketing the national debt. Initially the Bank was subjected to the same conditions as chartered corporations but once the first perpetual joint-stock companies were founded in the 19th century these conditions started to fade away. The colonial expansion led to a huge growth in overseas trade handled by the port of London. In consequence the City’s importance in international finance increased. A substantial banking community developed to meet the ever rising demand for capital and insurance. In the process, London overtook Amsterdam circa 1730, though it has to be stressed that the City was merely preoccupied with international finance and contributed little to finance Britain’s own industrial revolution. The large surplus of domestic savings that was accumulated during the 19th and early 20th century was mainly exported to the rest of the world (Plender and Wallace 1986). By the mid 1820s Britain was the major exporter of capital. Although the central banks in Berlin and Paris also maintained foreign balance, London was the undisputed leader in international finance. At the same time, Hamburg challenged London’s dominance in shipping but could not match its financial pre-eminence.

14

The future of European financial centres

Thus we can summarise that London had a major port, a tradition in banking, and it was the location of the capital as well as the centre of the railroad network. Since the building of the latter in 1830 London was easily accessible from all parts of the country. Until 1826 the Bank of England had the monopoly of joint-stock banking. This and the prospect for fuller and more effective use of surplus cash brought many banks to London, which led in consequence to an integration of markets. In addition, sterling became the major currency and was regarded to be as good as gold. Kindleberger comes to the conclusion that during the 19th century and up to the Great Depression ‘London was a world financial centre; Paris was a European financial centre’ (Kindleberger 1993: 263). As we have argued in the previous chapter the present situation is very similar, except that we can substitute Paris with Frankfurt. Kindleberger observes that while London was an efficient market, Paris’ strength was its money and capital market. The historical developments from 1914 onwards made it difficult for London to maintain its dominant role as a centre for foreign reserves, and for short- and longterm credit. When sterling left the gold standard the location of the main international financial centre shifted to New York. The inter-war years brought no change to this situation, and after World War II it was widely assumed that Britain, as a debtor nation which had been forced to sell off foreign assets, would play a dwindling part in the international financial arena. Sterling declined, and the relative size of the capital base and the ability to conduct international financial business was bound to shrink. While the government imposed exchange controls, the US dollar became the major currency. The proportion of world trade financed in sterling fell from 50 percent before World War II to 25 percent in the mid 1960s (Plender and Wallace 1986: 12). However, London was still a major player in insurance and shipping. The City was not alone in its proneness to historic accident. War put an end to Antwerp’s supremacy as a financial centre for northern Europe in the late 16th century, and completed the downfall of Amsterdam in the early 19th century. The late 1950s brought about a reversal of fortune for London. Its financial centre saw a revival as the eurodollar market developed. US banks and securities dealers were increasing the number and size of their European branches in an attempt to find a way around domestic capital controls as well as Regulation Q, which set limits on deposit rates that banks were allowed to offer. The US government also levied an Interest Equalisation Tax that made it unattractive for foreigners to borrow dollars in the USA. In 1966 and again in 1969/70 a number of US banks came to London to borrow dollars in order to increase their reserve balances in the USA. Much of the foreign branching was of a quite defensive nature. The move abroad was mainly intended to avoid losing customers rather than to increase profits. As US corporations moved to Europe, their banks followed suit. While in 1959 the number of overseas banks in London was a mere 45, it increased in the following decades reaching 351 in 1983 (Clarke 1986: 21). One might argue that it was sheer luck that London was reinvented as a major financial centre. Tough regulatory constraints in the USA made investors look elsewhere. London with its tradition of financial freedom appealed most to those who were searching for a new financial

The emergence of financial centres

15

market place. This enabled the City to develop first the eurodollar and subsequently eurocurrency markets. These offshore markets allowed business in foreign currencies to be conducted virtually free of regulation which in turn led to an ever increasing surge of financial institutions from abroad. Thus, London became a foreign banking centre and, by the 1970s, there were more US banks in London than in New York (Plender and Wallace 1986). The emphasis of this new non-sterling business was on the wholesale sector. Huge sums were transacted between countries, companies and financial institutions. Other factors in the City’s favour, which also support Kindleberger’s view, were the two oil crises of 1973/74 and 1979/80. The Organisation of Petroleum-Exporting Countries (OPEC) which used to bank with US institutions were afraid their deposits might be confiscated by the US government. Since their own banking systems were not sophisticated enough to absorb the huge surplus they turned to the UK. The financial system in Britain was only lightly regulated with a high degree of banking confidentiality, and the political system was regarded as neutral. Therefore, the OPEC countries assumed that the UK government would clearly distinguish between its role as custodian of foreigners’ funds and its wider political considerations. The language factor might also have played a role. In consequence, the eurocurrency activities continued to grow and a number of new financial products such as syndicated loans were put into operation. At the same time a large body of experts not only in finance but also in supporting services like accounting, marketing, legal advice, translating, and computing was built up in the City. This gave London the edge over its competitors in terms of infrastructure, resulting in self-sustaining growth by attracting ever more business.

Frankfurt Germany saw twice in its history the emergence of a single financial centre. At both occasions the development was political as well as economical. First, there was the rise of Berlin over Cologne, Darmstadt, Dresden, Frankfurt, Hamburg and Leipzig after Prussia’s victory over France in 1871. Second, Frankfurt gradually emerged as financial capital after World War II. Berlin’s securities activity in the finance of railroads made it the favourite banking place in the 1850s. It obtained an edge over Hamburg because the latter concentrated on merchant banking and had close ties to London. Hamburg was also relatively slow to specialise so that in 1860 the focus of banking was in Berlin. Its ascendancy over Frankfurt was mainly politically motivated. In addition Kindleberger (1978: 90) points out the nimbleness and the skill of bankers in Berlin, and that greater importance was given to railroad issues than to those of state entities. It should also been mentioned that it was very fashionable to have at least a subsidiary in Berlin. On the other hand, Deutsche Bank, which was founded in 1872 in Berlin, intended to focus on foreign trade but found it unsatisfactory to operate from Berlin. Thus, they set up a branch in London. In essence it can be summarised that domestic functions focused on Berlin while the finance of foreign trade was either conducted in Hamburg or in London. After World War II Berlin became isolated, and various political considerations led to the dominance of Frankfurt in financial

16

The future of European financial centres

services. Berlin had seen not only a concentration of Prussian but also of German state authorities. It hosted the central bank, the Reichsbank, and consequently was the preferred location for a large number of political as well as financial organisations. After the war the allies were determined not to allow a similar concentration of power again. The Bundesbank, or Bank Deutscher Länder as it was first called, was therefore established in Frankfurt instead of Bonn, the political capital. There were three other major factors that ensured the city’s supremacy in finance. Frankfurt Stock Exchange had the greatest turnover of all German exchanges and was soon to become a synonym for being the German stock exchange. In addition all big banks had their head offices in Frankfurt, and after the abolishing of the moratorium on foreign investment in Germany, the head offices of US-owned multinationals gravitated to the city. That the USA chose Frankfurt over any other location in Germany was due to its large and efficient international airport and to American governmental presence. All those factors gave Frankfurt a head start over other German cities. The role of the Bundesbank and the direction the economy took should not be underestimated in this process. Germany developed an open economy with free capital transactions. German banks were expanding internationally through joint ventures and overseas offices. Since the late 1950s the deutschmark (DM) was among the most favoured currencies in international financial markets. In this context, the central bank earned itself a reputation for being the guardian of a stable currency and low inflation. This reputation for competence, stability, reliability and efficiency was quickly transferred to the financial system in general and to Frankfurt as the main financial centre in particular.

Other centres Before discussing the implications of our findings so far, we will give an overview of the developments in some other European countries to provide a more rounded picture.

France France has a long tradition of centralisation that goes back to the time of Louis XIV. Even though the French Revolution made banks retreat to their origins in Geneva, Germany or overseas, once the political situation was stabilised Paris emerged as financial centre. Kindleberger (1975) argues that this was not only due to administrative centralisation but also to tradition and a well developed communications network.

Italy In Italy, the emergence of the financial centre was not so much a decision in favour of Milan but rather a decision against Rome, the political capital, and Turin, the industrial capital. Rome obtained the status of capital quite late in 1870, it was badly

The emergence of financial centres

17

located relative to the productive areas, and had a poor transport system. The decision against Turin, too, was mainly founded on locational aspects in conjunction with political reasons (Lees and Eng 1975).

Switzerland The financial history of Switzerland began with several financial centres starting off on an equal footing. Zürich became the main centre at the end of the 19th century. It was renowned for the pushiness of its bankers and had an additional advantage through its location on the railroad system. It also established a comparative advantage by offering only minimally regulated banking and investment services to private individuals.

Amsterdam We have already outlined the rise and decline of Amsterdam as we went along. In addition it should be mentioned that due to the Dutch East India Company and its innovations in reporting, the city developed the first information network in Europe in the 17th century. This network was built on an internal source of information which was then extended to other merchant dealings (Neal 1990). It brought about a self-sustaining growth with more merchants, agents and other participants moving to Amsterdam. This in turn increased the information flow further and allowed the city to set up an information monopoly. The Netherlands were very efficient in raising taxes to finance government expenditure. Low interest rates kept debt repayments down. The country, and particularly Amsterdam as its financial centre, gained a reputation for being superior to other places as far as the clearing of bills, the exchange of currencies, and the provision of credit were concerned. This success enabled agents to invest in foreign stock companies, thus furthering its reputation. Moreover, the position of Amsterdam was supported by a thriving economy (Kennedy 1989). The decline of Amsterdam started with the beginning of the fourth Anglo-Dutch war (1780–84) and the simultaneous decline of the Dutch East India Company, all of which led to market stagnation. This process was further advanced in 1793 when France declared war on the Netherlands and a massive capital flight in connection with the exodus of human capital and expertise drained the financial market.

Implications for future developments Financial markets are needed mainly for two reasons: to finance trade, and to provide short- and long-term capital in order to finance production and distribution. The elementary features of financial markets are lending and borrowing money, the price of money, and the activities of financial intermediaries. We have shown that the factors that lead to the formation of a single dominant financial centre within a country, tend to be the same as those that produce an international centre. In the

18

The future of European financial centres

following we examine what is necessary to become a financial centre, the pillars on which London’s supremacy is based, and finally have a first outlook on possible future developments.

Ways to become a financial centre The emergence of international financial markets is generally influenced by natural and socio-political circumstances, the participants in the market (e.g. individuals, governments, financial institutions), the development of financial instruments as well as the volume and price of transactions. Up to a certain degree of concentration, positive externalities and economies of scale appear to outweigh diseconomies, therefore favouring centralisation. The continuous reduction in the costs and difficulties of transport as well as communication over the last two centuries has favoured the formation of only a few major financial centres. At present these are London in the European time zone, New York in America, and Tokyo in Asia. Financial centres develop to accumulate talent and knowledge necessary to develop financial markets in one convenient place. An important feature is to have strength in both breadth and depth. The key determinants for the location of a financial centre are economies of scale and the relative conditions between centres. Centres which offer a liberal financial regime free of political interference act like a magnet to funds. Deregulated markets encourage greater innovation, a phenomenon to be seen in e.g. the euromarkets, markets for derivatives, and international syndicated loans. Britain was the foremost colonial power. Sterling emerged as trading currency and subsequently as reserve currency. London was the main capital exporter, thus fostering global economic growth. Sterling and London declined in importance in step with the UK’s political and economic decline. The City experienced a revival in the 1960s through first the eurodollar and later the eurocurrency market. There are essentially two ways of becoming an international financial centre as opposed to a European, national or regional one. The first of those is to expand on the back of economic growth and international trade, which is how the City attained its supremacy in the 19th century. Second, a location has to create a political, fiscal, regulatory and institutional environment in which international financial business can thrive almost regardless of the fortunes of the home country. This approach has been adopted by most offshore centres which have developed financial business on a scale disproportionate to the rest of their economic activities.

The supremacy of London In the 19th century London took advantage of its economic strength and strong position in international trade. Consequently, it has been the world’s financial centre for most of the 19th century, and was only superseded by New York in the 20th century. Another shift could be observed through the emergence of the eurodollar market which even though it is spread globally is centred in London. One of the advantages of London is the existence of many markets, such as commodity, metals,

The emergence of financial centres

19

stock, currency and insurance, in a relatively small location. A financial centre that hosts many closely interrelated markets is superior to one that specialises like e.g. Zürich in gold. The more investors a location attracts, the more liquidity and efficiency it can offer. London was the first host to the eurocurrency business, the first major country to abolish exchange controls and also the first country with a radical stock market reform. The absence of heavy-handed government regulation has made the City an attractive place for footloose foreign financial firms whose enterprise accounted in large measure for the City’s continuing success. At the same time this tradition of wide-ranging rights to run their own affairs contributed to a lacklustre performance of many City firms (Plender and Wallace 1986). This long tradition of financial freedom resulted in a high concentration of international banks. Plender and Wallace (1986) also stress the importance of prestige and perks such as the ‘Ascot factor’. In finance much attention is paid to the time zone. London can deal with the Far East and New York during a single working day which is of particular relevance for securities trading. Although this is impossible for New York and Tokyo, it does not explain why London is ahead of other European centres. Even in decline London has maintained its position as the largest European centre which manifests itself e.g. in the number of foreign banks as well as the volume of international business. Less stringent regulation and more benign fiscal policy made the city attractive to US investors. We will show later (Chapter 3) that language and a tradition of political and social stability all play an important role in the decision-making process of firms. Once a financial centre has established itself as an attractive location, growth becomes self-sustaining; as a result a welldeveloped body of supporting professions like lawyers and accountants will be present.

An outlook Historically the basis for shifts in dominant financial centres were changes in military power, economic capacity, and adaptability to economic change. In the case of Amsterdam the Dutch East India Company was an exogenous shock that gave Amsterdam an advantage over other centres. Exogenous changes in technology or trade might therefore be necessary to develop a new system with greater potential to replace the existing network. Of great importance is a well developed banking sector. Goldsmith argues that it ‘accelerates economic growth and improves economic performance to the extent that it facilitates the migration of funds to the best user, i.e. to the place in the economic system where the funds will find the highest social return’ (Goldsmith 1969: 400). We have seen that financial centres have the tendency to polarise in one main place. In Europe various national centres compete to become the main European centre. A strong currency might be helpful initially for the establishment of a leading financial centre. However, it is neither necessary nor does it guarantee subsequent success. Economies of scale predict one centre but not which one. Technological developments suggest that physical financial centres are no longer needed. On the

20

The future of European financial centres

other hand only the concentration in centres allows the realisation of economies of scale.

Notes 1. See also table 2.3 in appendix 2.1. 2. In a less location-theory specific interpretation this can also include quality of life, entering a market previously dominated by an arch rival and so forth. 3. See also appendix 2.2.

Appendix 2.1: Motives for EU alliances Pelkmans (1997) shows that ownership, internationalisation and location characteristics have to be satisfied before firms enter into intra-EU strategic alliances. While a strategic alliance is, of course, not quite the same as relocating a firm Table 2.3 proves that although some factors are more important than others there is indeed no overriding determinant for a firm’s decision in this context.

Appendix 2.2: Economic Darwinism As pointed out before in times of economic downturn, and especially during worldwide recessions, weak financial institutions will usually be weeded out. Depending on the scale of such an event this might lead to the establishment of a new, dominant financial centre. Two concepts spring to mind immediately when one approaches the topic from this direction: Schumpeter’s theory of economic evolution, and the Darwinian process of evolutionary selection. Kelm (1996) brought the two together in order to show the nature of the evolutionary forces that drive economic systems, and the relationship between evolutionary theory and equilibrium analysis. In this appendix we present a summary of Kelm’s work and draw conclusions for financial centres. According to Schumpeter, evolution is a process of endogenous change. While he defines a stationary process as one that ‘does not change of its own initiative, but merely [...] under the influence of events which are external to itself’ (Schumpeter 1951: 161) an evolutionary process is seen as one due to change of its own initiative. Kelm (1996) points out that Schumpeter’s definition of evolution is neutral regarding the forces that determine the process of endogenous change. Darwinian concepts such as natural selection are neither included nor excluded. Based on this Kelm (1996: 3) suggests that although not explicitly mentioned, ‘Schumpeter’s theory of economic evolution had more elements in common with it [Darwinian theory] than the mere concern with endogenous change that is implied by the term evolution.’ In order to prove his hypothesis Kelm compares the mechanism that drives each theory. Of central importance here is Schumpeter’s concession that it may be [...] that certain aspects of the individual enterprise system are correctly described as a struggle for existence, and that the concept of survival of the fittest in this struggle can be defined in a non-tautological manner [...].

The emergence of financial centres

21

Table 2.3 Motives for EU alliances (by industry)1 Tech Airtr Aeroeq Comp Food Chem Pharma Biotech Telecoeq Semicon Autoco Vehiclea + important

Cost

Inno

R&D

Spec

NProd NGeo +

+ *

+ * +

+ * * + + +

+ + +

+ * + * +

Mass * *

+ *

Scale Withdr * + +

* +

+

+ + +

* + + +

*

+ + *

* +

+

* very important

Sectors: Airtr: Air transport; Aeroeq: Aerospace equipment; Comp: Computers; Food: Food and drinks; Chem: Chemicals excluding pharmaceuticals; Pharma: Pharmaceuticals; Biotech: Biotechnology; Telecoeq: Telecom equipment; Semicon: Semi-conductors; Autoco: Auto components; Vehiclea: Vehicle assembly. Factors: Tech: Identifying and obtaining new technologies; Cost: Achieving or retaining cost leadership; Inno: Search for innovation even if possible alone; Research and Development (R&D): R&D cost sharing; Spec: Survival through specialisation on core competences; NProd: Exploiting new product opportunities; NGeo: Exploiting opportunities in new geographical markets; Mass: Re-establish critical mass; Scale: Economies of scale; Withdr: Orderly withdrawal. 1. This table is based on Pelkmans (1997: 160).

But if this be so, then these aspects would have to be analyzed with reference to economic facts alone and no appeal to biology would be of the slightest use. (Schumpeter 1954: 789) The exclusion of biological facts has been accepted by most evolutionary economists. This is not so much a snub for biology but confirms the insight that it might be advantageous to begin with a general definition of evolution before applying it to specific cases such as economics1. Thus the utilisation of Darwinism for the process of economic evolution fulfils the purpose of formulating a general model which ‘explains a process of endogenous change by the interaction of several fundamental mechanisms’ (Kelm 1996: 5). Having established the affinity between Darwin and Schumpeter, Kelm (1996: 7) proceeds by appositely asking the question ‘What remains of Darwin’s theory if we strip it of everything that is specifically biological about it?’ This process allows the isolation of three mechanisms that drive evolutionary change: • information storage (preservation of stable characteristics) • endogenous change (generation of new variations) • selective retention (increase in the frequency of some variation relative to others).

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The future of European financial centres

Schumpeter’s work deals with each of these mechanisms as they can be applied to economics. First, information storage is defined as business routine. The routines of institutions and/or individuals contain information such as the rules that provide the framework for certain behaviour. The inherent inflexibility of rules perpetuates their stability which in turn preserves diversity2. Next, endogenous change in the business world is driven by innovation3. Or as Schumpeter (1942: 83) put it ‘The fundamental impulse that sets and keeps the capitalist engine in motion comes from the new consumers’ goods, the new methods of production [...], the new forms of industrial organization that capitalist enterprise creates.’ Schumpeter’s analysis of innovation and entrepreneurship as the pivotal source of endogenous change illuminates an important difference between economic and biological evolution. The latter states that mutation is random4 while Schumpeter implies that elements such as rationality, intuition, perceptiveness and leadership are crucial to entrepreneurship. Thus, endogenous change in economic systems is facilitated by human agency and is not random. Finally, selection retention in Schumpeter’s framework is approached as learning and competition. Although biology has added random genetic drift to the category of selective retention, natural selection is the predominant concept in evolutionary biology. According to Schumpeter, the aforementioned human agency provides one mechanism of selective retention. Innovations, if successful, are imitated. The interaction of the two processes is regarded as cumulative learning. The notion of competition refers to the differential survival of firms and is thus the economic analogy to Darwin’s concept of natural selection. Kelm in his concluding remarks elucidates two important points. The inherent inefficiencies that economic evolution has in common with all other evolutionary processes, in particular the suboptimality of its outcome caused by path dependency, seem to constitute a prima facie case for state intervention. In assessing the actual need for political action, however, it is important to recognise that economic evolution, unlike biological evolution, involves conscious adaptive forces that to some extent mitigate the inherent limitations of the unconscious force of natural selection. (Kelm 1996: 28) Based on this he infers that Schumpeter’s analysis of economic evolution incorporates a comprehensive and highly relevant evaluation and application of the Darwinian concept of ‘guided variation, biased transmission, and natural selection, which interact in market economies to generate productive growth’ (Kelm 1996: 40). In Table 2.4 the analogies between Darwin and Schumpeter are summarised. Additionally we show the mechanisms that might drive the evolution of financial centres5.

The emergence of financial centres

23

Table 2.4 Evolutionary mechanisms Mechanism

Darwin

Schumpeter

Financial centres

Information storage

Preservation of stable characteristics Generation of new variations Increase in the frequency of some variations relative to others

Business routine

Tradition/ economies of scale Innovation/ leadership Competition/ networks

Endogenous change Selective retention

Innovation/ entrepreneurship Learning/ competition

Appendix Notes 1. See also Nelson (1995). 2. Schumpeter (1954) discussed this point in the context of (his critique of) the Walrasian model. 3. In biology endogenous change is triggered by mutation and recombination. Kelm (1996: 12) argues that ‘since recombination results from sexual reproduction which does not correspond to any analogous process in economic systems, only mutation can serve as a useful analogy’. However, we would argue that mergers are a form of recombination. 4. The chance that mutation occurs is not affected by its potential usefulness. 5. The factors listed in Table 2.4 under financial centres are based on the analysis in Chapter 2. The empirical study that follows might well throw a different light on some of these elements.

3 On the optimal design of an international financial centre

In the previous chapter we have shown how financial centres emerged historically. We now turn to the question of how an international financial centre should be designed in order to become the leading financial marketplace. The findings presented in this chapter are largely based on a questionnaire survey of the views professionals and academics have on financial centres. Bankers, traders, consultants, governments, central bankers and others involved in the financial markets, either in practice or in theory, in several countries were asked to complete a questionnaire with special regard to London and Frankfurt. The results from this survey will then be compared to the findings of Abraham et al. (1993) and those of researchers from the Institut für Kapitalmarktforschung (IfK) (1990) in Frankfurt. We will also briefly refer to a study conducted by the Centre d’Observation et de Prospection Sociale (COPS) in 1986. Thus, we cover a period of ten years during which substantial changes in the working of financial markets took place. At the end of this chapter we should be able to demonstrate whether London is ahead of its European rivals due to the reasons economic theory and the historical analysis predict, or whether other factors are at work.

Three studies on financial centres The three studies are outlined in reversed chronological order starting with our own 1996 questionnaire before describing the panel study by Abraham et al. (1993) in combination with the COPS research, and finally an earlier survey by the Institut für Kapitalmarktforschung (IfK 1990).

The 1996 survey A total of 278 questionnaires were sent to individuals and institutions working in the area of finance. In order to account for differences in the recipients’ professional capacities, five slightly differing questionnaires were developed. Below is the breakdown of the 128 returns1: • 19 stock and derivatives exchanges (out of 30)

On the optimal design of an international financial centre

25

• 72 banks, investment firms, and financial consultancies in five countries with their headquarters in eight countries (out of 150) • 5 central banks (out of 19) • 1 national government2 (out of 19) • 31 academics, financial journalists and other researchers in seven countries (out of 60). This constitutes a response rate of 46 percent. The composition of the sample offered itself for some questionnaires, like the ones to central banks, governments, and exchanges in the EU plus main players outside the EU. Banks, investment firms and financial consultancies were chosen for several reasons. With some institutions there were already established contacts which made a response more likely. Some firms were chosen according to their importance in international financial markets. It was also attempted to achieve a country-spread corresponding to the importance of a location, i.e. to strike the right balance between London, Frankfurt and Paris. Academics, financial journalists and others working in finance were mainly selected at random. All questionnaires started with three preliminary questions to establish from where responses were received, the location of respondents’ head offices, and their position within a firm. Answers to the first two questions make it possible to trace any country-specific views on the remainder of the questionnaire, whereas the position of the respondent is needed to ensure that individuals with adequate information and competence complete the questionnaire. The questionnaires for exchanges3 were sent to EU stock and derivatives exchanges as well as to exchanges in other European countries (Switzerland and Norway) and institutions in Chicago, Hong Kong, New York, Singapore, Tokyo, and Vancouver Recipients were asked to firstly choose from a list of 23 criteria what in their opinions are the most important elements for financial institutions when choosing a location, and why they think London is the leading financial centre. In this context, the next question asked which financial centre poses the greatest challenge to London. If the answer was not Frankfurt, recipients were prompted to give a reason for their view. The second set of questions relates to the location of the recipients’ exchange. Issues covered in this section were intended to evaluate which exchanges are regarded to be the strongest rivals, what recipients see as their main strengths and weaknesses, and the adequacy of government policies to ensure the competitiveness of the host financial centre. The final part of the questionnaire deals with European legislation and its potential effects on the competitiveness of European financial centres. Respondents at banks, investment firms and financial consultancies4 were asked to reveal the main reasons why their firm chose a particular site rather than the most important criteria for choosing a financial centre in general. Bearing in mind changes in the financial sector of most countries, this questionnaire also contains an option to indicate which financial location respondents would choose at present. The questionnaire itself has the same structure as the one for exchanges.

26

The future of European financial centres

Out of the 72 returns from this group of respondents, 26 were from banks, 25 from investment firms, and 21 from financial consultancies. All these firms are located in London, Frankfurt or Paris with the exception of two consultancies in Zürich and five consultancies and investment firms in Amsterdam. The headquarters, however, are spread more widely as can be seen from Table 3.1. The questionnaire for central banks5 adheres very closely to the one sent to exchanges. The main difference here is that central banks were not asked about their main rivals since they are not in competition with each other. In addition to the usual set of questions, governments6 were asked to rank the main financial centre in their country with regard to a list of 23 criteria. Instead of evaluating the adequacy of the strategies they pursue7 to ensure that their country hosts an internationally competitive financial centre, they were questioned about their policies in the areas of infrastructure, fiscal regulation, market regulation, innovation, technology, banking sector and ‘other’. Finally, the questionnaire to academics, financial journalists and others working in finance8 followed the general pattern described above. The only diversion can be found in the very last question, where respondents should list and explain the necessary improvements financial centres other than London need to make in order to catch up with the latter.

The Abraham et al. panel study Abraham et al. (1993) published two studies on the competitiveness of European International Financial Centres. The first study, completed in 1991, comprised London, Paris, Frankfurt, Luxembourg, Zürich and Brussels. In the following year they analysed the position of Amsterdam, Copenhagen, Madrid, Milan and Brussels. They produced a list of 47 characteristics of financial centres, which they roughly categorised into factors of production (e.g. attraction of foreign capital), man-made environment (e.g. bank secrecy), regulatory framework (e.g. organisation of the stock exchange), and fiscal regulation (e.g. withholding tax). The complete list is reproduced in appendix B1.

Table 3.1 Headquarters of institutions Country Canada France Germany Japan Netherlands Switzerland UK USA Total

Number of institutions 1 10 13 9 6 4 17 12 72

On the optimal design of an international financial centre

27

For each study they established a panel of ten to twenty experts, mainly bankers and academics. These experts were then asked to weight the above-mentioned criteria in the following way: (A) (B) (C) (D)

Factors of production Man-made environment Regulatory framework Fiscal regulation

0.280 0.250 0.225 0.245

Based on these weightings panel members scored each of the 47 criteria for each centre using a scale of one to five, with one meaning excellent. The results are presented later under ‘The findings’.

The IfK questionnaire The IfK (1990) at the University of Frankfurt questioned 115 American, Japanese, French, British, Swiss and German banks as well as some banks from other countries about their criteria when choosing an international financial marketplace. The interviews were pursued in London (36), Frankfurt (45) and Paris (34) with the intention to evaluate the competitiveness of Frankfurt as compared to London and Paris9. The composition of the sample is reproduced in Table 3.2. The questionnaire was divided into two parts, the first of which comprised questions for verbal response. Foreign banks were asked why they had chosen London, Frankfurt or Paris respectively as their preferred location. The corresponding question for domestic banks gave respondents the choice between the two foreign centres. Thus, interviewees in e.g. Frankfurt were asked to explain whether and why Table 3.2 Statistics of institutions1 London I

II

Paris

Frankfurt

Total

US banks Japanese banks French banks German banks UK banks Swiss banks Other banks

6 6 — 2 9 4 6

7 2 14 2 1 — 2

10 10 3 9 2 4 7

23 18 17 13 12 8 15

All banks

33

28

45

106

Stock exchanges Central banks Others Total

1 1 1 36

4 1 1 34

— — — 45

5 2 2 115

1. Translated from IfK (1990: A1).

28

The future of European financial centres

they would prefer London or Paris if they had to choose between the two10. The next two questions in this verbal section were the same for foreign and domestic institutions. Question two asked about the main criteria for a European financial centre. The third question raised the issue whether the site of the European Central Bank (ECB) has any significance for the relevance of a financial centre. Interviewees were also asked when and where they expected the ECB to be established. The second part of the survey consists of a questionnaire in which respondents are asked to rank 27 criteria11 according to their importance for a financial centre, and then rank the performance of the three centres – London, Frankfurt and Paris – with regard to those criteria.

The findings We start by presenting the results of our own 1996 survey, before looking at the findings of Abraham et al. (1993) and the IfK (1990). Each survey is analysed within itself. A comparative study is presented under ‘An Analysis’.

The 1996 survey At the beginning of this section, let us recall that questionnaires were sent to five different groups. These are individuals and institutions working in the field of financial markets namely academics, banks, investment firms and financial consultancies, stock and derivatives exchanges, central banks, and government departments. Since only one of the latter completed the questionnaire, we largely ignore them in this chapter. Although only one government institution responded by completing the questionnaire it should be noted that several more were very helpful in forwarding other relevant information such as transcripts of speeches given by ministers, position papers, and so forth. Nonetheless, in the following we only present the views of the remaining four groups. The first question asked respondents to indicate those criteria which they regard as the most important ones when choosing a financial centre. In order to make a comparison of the views of different groups easier, the respective rankings are presented in Tables 3.3 to 3.512 which refer to the following list of criteria. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11.

Availability of capital Human resources Language Infrastructure Operation costs Economic growth of host country Strength of currency Banking sector Bank secrecy Independence of central bank Automatic continuous system for transactions

12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23.

Circulation of information Settlement of transactions Diversity and size of markets Diversity of financial products Volume of transactions Presence of international banks Innovation Financial tradition Political stability Market regulation Fiscal regulation Commissions

On the optimal design of an international financial centre

29

Table 3.3 The most important criteria1 Rank Academics

Investment firms

Exchanges

Central banks

1 2 3 4 5 6 7 8 9 10

Human res (2) Markets (14) Fin products (15) Internat banks (17) Fin tradition (19) Information (12) Market reg (21) Infrastructure (4) Transac vol (16) Banking (8)

Transac vol (16) Markets (14) Fin products (15) Market reg (21) Op costs (5) Human res (2) Internat banks (17) Transac settle (13) Fin tradition (19) Information (12)

Human res (2) Infrastructure (4) Pol Stability (20) Op costs (5) Currency (7) Fin products (15) Transac vol (16) Internat banks (17) Capital (1) Econ growth (6)

1.

Capital (1) Markets (14) Human res (2) Internat banks (17) Fin products (15) Market reg (21) Transac vol (16) Op costs (5) Transac settle (13) Infrastructure (4)

A more detailed and stylised breakdown is presented in C1.

Table 3.4 The less important criteria Rank Academics

Investment firms

Exchanges

Central banks

11 12 13 14 15 16 17 18 19 20 21 22 23

Commissions (23) Language (3) Transac settl (13) Innovation (18) Currency (7) Capital (1) Pol stability (20) Bank secrecy (9) Central bank (10) Op costs (5) Econ growth (6) Electronic set (11) Fiscal reg (22)

Pol stability (20) Capital (1) Infrastructure (4) Banking (8) Commissions (23) Innovation (18) Language (3) Electronic set (11) Currency (7) Bank secrecy (9) Econ growth (6) Central bank (10) Fiscal reg (22)

Banking (8) Bank secrecy (9) Central bank (10) Electronic set (11) Markets (14) Innovation (18) Fin tradition (19) Market reg (21) Fiscal reg (22) Language (3) Information (12) Transac settl (13) Commissions (23)

Innovation (18) Language (3) Information (12) Fiscal reg (22) Pol stability (20) Fin tradition (19) Commissions (23) Banking (8) Currency (7) Electronic Set (11) Econ growth (6) Bank secrecy (9) Central bank (10)

Table 3.5 Overall ranking of criteria Rank Criterion 1 2 3 4 5 6 7 8 9 10 11 12

Human resources (2) Diversity/size of markets (14) Diversity of financial products (15) Presence of international banks (17) Volume of transactions (16) Market regulation (21) Infrastructure (4) Operation costs (5) Availability of capital (1) Financial tradition (19) Political stability (20) Banking sector (8)

Rank 13 14 15 16 17 18 19 20 21 22 23

Criterion Settlement of transactions (13) Circulation of information (12) Strength of currency (7) Language (3) Innovation (18) Commissions (23) Fiscal regulation (22) Automatic continuous system for transactions (11) Bank secrecy (9) Economic growth of host country (6) Independence of central bank (10)

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The future of European financial centres

Evaluating the answers respondents gave to question one, which are summarised in Tables 3.3 to 3.5, we can see that there is a closer correspondence between banks/investment firms/financial consultancies and academics than between the former and exchanges13. The first two groups agree on the importance of the diversity and size of markets (14), the presence of international banks (17), and market regulation (21). They have identical views on the unimportance of an automatic continuous system for transactions (11), and regard language (3) as being of medium relevance when choosing a financial centre. Their opinions are also closely related on issues like human resources (2), the diversity of financial products (15), and political stability (20) in the top half, as well as economic growth of the host country (6), bank secrecy (9), and the independence of the central bank (10) at the bottom of their respective rankings. However, besides these agreements we can observe marked differences in seven areas. Academics rank the availability of capital (1), operation costs (5), and fiscal regulation (22) significantly higher than banks/ investment firms/financial consultancies. The latter in turn put more stress on the banking sector (8), the circulation of information (12), financial tradition (19), and commissions (23). All three groups – academics, banks/investment firms/financial consultancies and exchanges – agree on the diversity and size of markets (14) as being the second most important criterion. In accordance with the first two groups, exchanges regard the economic growth of the host country (6), bank secrecy (9), and the independence of the central bank (10) as not very relevant. The most striking disagreement can be found with respect to the volume of transactions (16). Exchanges expect this to be of utmost importance for the choice of a location, whereas the other two groups attach medium weight to its significance. Of particular interest is, in this context, the relationship between banks/investment firms/financial consultancies on the one side and exchanges on the other side. After all, the latter attempt to create an environment that attracts the former to conduct their business at a certain location. From Tables 3.3 and 3.4 we can see that exchanges regard criteria like the availability of capital (1), operation costs (5), settlement of transactions (13), volume of transactions (16), political stability (20), and market regulation (21) as more important than banks/investment firms/financial consultancies. Criteria (5) and (16) especially provoke different views. Banks/ investment firms/financial consultancies on the other hand find human resources (2), language (3), infrastructure (4), circulation of information (12), and financial tradition (19) much more relevant than exchanges. This means that the two groups disagree on the importance of almost half of the listed criteria14. We will discuss the implications of this under ‘An Analysis’. An evaluation of central bank views is more problematic since it is based on five responses only. Still, we can find some clear similarities and some equally clear differences. Like the other three groups, central banks consider human resources (2), the diversity of financial products (15), and the presence of international banks (17) as very important. Economic growth of the host country (6), bank secrecy (9), and the independence of central banks (10), criteria which all others ranked towards the bottom end, are of higher importance to central banks.

On the optimal design of an international financial centre

31

At this point we should mention the specific comments made on the following criteria: human resources (2); infrastructure (4); innovation (18); financial tradition (19); market regulation (21); fiscal regulation (22); and, finally, commissions (23)15. All three groups stressed the importance of skilled, already trained personnel with experience. Banks/investment firms/financial consultancies were particularly specific in requiring investment banking professionals, analysts, and sales people. Furthermore, exchanges and central banks were keen on management and IT skills. In terms of infrastructure (4), banks/investment firms/financial consultancies stressed the relevance of the geographical location of a financial centre, transport, the presence of exchanges, as well as trading and settlement facilities. Exchanges consider the size of financial markets and data communications as particularly important whereas central banks mentioned telecommunications in this area. The latter also commented on criterion (18) where they believe financial derivatives deserve special attention. Financial tradition (19) was specified as the good reputation of the City of London by banks/investment firms/financial consultancies, and as propriety by central banks. The benevolent guidance of the Bank of England is an important factor for some banks/investment firms/financial consultancies when considering the position of London as a financial centre in the context of market regulation (21). Exchanges stress factors like flexibility and investor protection, while central banks regard the general area of banking and financial market supervision as essential. Of the three groups, only central banks view fiscal regulation (22) as being of some importance. They highlight the eminence of the taxation of intermediaries, income, and capital gains. The main concerns regarding commissions (23) are (no) stamp duties on transactions as mentioned by banks/investment firms/ financial consultancies, and business soundness as specified by exchanges. Finally, each group16 was asked whether there were any other criteria which are important when choosing a location. Academics point to the depth and breadth of markets, economies of scale arising from the conglomeration of other institutions, competition, and well monitored markets. Banks/investment firms/financial consultancies who are at present located in London stress that the major attractions for their choice were to have a base in the largest financial centre, and to benefit from worldwide communications. Exchanges point out that the proximity to potential customers is an important criterion when choosing a location. Before moving on to the next issue let us turn to the overall ranking of the 23 criteria. Appendix C11 provides a breakdown of the ranking for all groups and one that excludes central banks17. There are two results which are particularly striking18. First, the specific characteristics of financial centres are weighted as being more important than factors like the surrounding environment, e.g. political stability. Second, we can see that the six top ranked elements are close together. After a relatively large gap follows a second group from rank seven to twelve, another group comprises ranks thirteen to sixteen. The remaining criteria are significantly far off and placed at the bottom of the ranking. If we exclude the central bank results from the ranking, we find again that the first six criteria, which are the same as before

32

The future of European financial centres

though in a different order, are very close. The spread between the rest is, however, not as wide as the one for all groups. Having thus shown what are regarded as the most important criteria when choosing a financial location, we now look at the views on why London is the leading financial centre19. We then compare the answers to those two questions, and check whether London leads other centres like Frankfurt because it fulfils all those criteria or whether there are other reasons for its strong position. The individual results for this question are presented in appendix A11. Academics believe that London’s leadership is mainly due to the availability of capital, financial tradition, the diversity and size of markets, and the presence of international banks. Banks/investment firms/financial consultancies regard the availability of capital as irrelevant, and stress instead the factor of human resources. This is followed by the diversity and size of markets, financial tradition, the presence of international banks, the diversity of financial products, and the banking sector. Exchanges agree on the importance of human resources though they consider the volume of transactions as even more significant. The latter factor, again, is not at all mentioned by banks/investment firms/financial consultancies in order to explain London’s success. Exchanges also believe in market regulation and financial tradition as highly relevant factors. Central bank views are concentrated on criteria (14) to (17), and (19). Table 3.6 shows the overall ranking of the criteria with regard to London’s leading role. Hence, human resources (2), financial tradition (19), and the diversity and size of markets (14) are regarded as major assets for London. Other areas where the city fares particularly well are the presence of international banks (17), the diversity of financial products (15), and the state of market regulation (21). On the other hand, factors like fiscal regulation (22), political stability (20), infrastructure (4), the strength of the currency, or bank secrecy (9) to name just a few play no important part in explaining London’s dominance. Table 3.6 Reasons for London’s leadership1 Rank Criterion

Rank Criterion

1 2 3 4 5 6 7 8 9 10 11 12

13 14 15

Human resources (2) Financial tradition (19) Diversity and size of markets (14) Presence of international banks (17) Diversity of financial products (15) Market regulation (21) Banking sector (8) Innovation (18) Availability of capital (1) Language (3) Operation costs (5) Volume of transactions (16)

1. See also appendix C12.

Fiscal regulation (22) Political stability (20) Infrastructure (4) Economic growth of host country (6) Strength of currency (7) Bank secrecy (9) Independence of central bank (10) Automatic continuous system for transactions (11) Circulation of information (12) Settlement of transactions (13) Commissions (23)

On the optimal design of an international financial centre

33

We have now established the characteristics which are regarded as the most important ones for the success of a financial centre in general and specifically those that are responsible for the dominance of London. A further aspect of interest in this context is a comparison of the criteria that are regarded as being of general importance for the competitiveness of an international financial centre and those which give London the edge over other locations. From Table 3.7 we can tell that London is leading due to seven of the ten most important characteristics. Human resources (2), the presence of international banks (17), market regulation (21) and the availability of capital (1) are exactly convergent whereas the diversity and size of markets (14), the diversity of financial products (15) and financial tradition (19) are in a different order. Financial tradition, in particular is ranked only tenth overall, but is regarded as being the second most important reason for London’s leadership. The banking sector (8), innovation (18) and language (3) are considered as being significant for London’s position but as not very important for financial centres in general. Another marked difference is that the volume of transactions (16), though ranked fifth overall is of no importance for London. Similarly, infrastructure (4) is generally one of the essential areas in which financial centres have to excel but is ranked last for London20. The most striking result as represented in Table 3.7 is, however, that human resources (2) is the key factor for the success of financial centres and is also the prior reason why London is leading other financial centres Having thus established the major characteristics a location has to adopt in order to become an international financial centre as well as the most important reasons for London’s dominance, respondents were then asked which financial centre, if any, poses the greatest challenge to London21. Frankfurt emerged as the clear ‘leader of the pack’ with 58 respondents regarding it as the main challenger to London. Paris and Dublin, as the only other European centres considered, are way behind Frankfurt with 24 and one vote respectively. Although Frankfurt’s lead over Table 3.7 A comparison of Tables 3.5 and 3.61 Rank Most important criteria overall

Reasons for London’s leadership

1 2 3 4 5 6 7 8 9 10

Human resources (2) Diversity/size of markets (14) Diversity of financial products (15) Presence of international banks (17) Volume of transactions (16) Market regulation (21) Infrastructure (4) Operation costs (5) Availability of capital (1) Financial tradition (19)

Human resources (2) Financial tradition (19) Diversity and size of markets (14) Presence of international banks (17) Diversity of financial products (15) Market regulation (21) Banking sector (8) Innovation (18) Availability of capital (1) Language (3)

1.

See also appendix C13.

34

The future of European financial centres

Paris is very significant, and no other European centre is seriously considered, the most striking result is that as many respondents as view Frankfurt as the main challenger to London believe that there is no challenge at all, and London is highly secure in its dominant position22. Banks/investment firms/financial consultancies were next asked which location outside London they would consider for the conduct of their business. A majority of 32 see no alternative to London. Those who would be willing to choose any other financial centre again thought that Frankfurt is the most suitable (19), followed by Amsterdam and Paris which are both regarded equally as alternatives to London (7 votes each). Luxembourg (6), Dublin (5), Milan (3) and Zürich (3) are the other locations mentioned. The following section of the survey deals with strategies and legislation. Evaluating the opinions of all groups, the majority of respondents believe that the government of their host country23 pursues the wrong strategy to ensure that the location is competitive in international terms24. The impact of EU legislation on European financial centres is generally expected to be beneficial. A positive effect is expected by 74 respondents, mainly due to the implementation of the Investment Services Directive (ISD) and the Capital Adequacy Directive (CAD). Of the 49 who fear single market legislation will put European centres at a disadvantage, most pointed out that they believe regulation is generally harmful to the competitiveness of financial centres25. In this context respondents were asked to indicate which financial centre they expect to gain most from the single market26. The majority think Frankfurt (60) will benefit more than any other centre, followed by Paris (33), London (15) and Luxembourg (11). The most frequent reason given for this ranking is that Frankfurt is perceived as being the most heavily regulated financial centre and will thus not need an adjustment period to comply with EU legislation for financial services. We will analyse the findings from this survey as from all other surveys later in the chapter. However, after describing the results from the 1996 survey we can tentatively conclude at this stage that the financial centre of London is in a league of its own, and that in most areas Frankfurt is regarded as being ahead of Paris. There are only very few aspects where any other European locations are seriously considered as being of relevance.

The Abraham et al. panel study Before discussing the results of the study by Abraham et al. (1993) let us briefly recall the four groups in which they categorised their 47 characteristics of financial centres. They are factors of production (A), man-made environment (B), regulatory framework (C), and fiscal regulation (D). After weighting the criteria the centres were ranked according to their score in descending order of excellence except for Brussels which provides a link between the two studies. The two most striking findings of Abraham et al. (see Table 3.8A) are the undisputed leadership of London, and the fact that both Luxembourg and Amsterdam scored better than Frankfurt and Paris. Considering the results of the weighted 47 characteristics Abraham et al. conclude that European financial centres can be divided into five groups:

On the optimal design of an international financial centre • • • • •

35

London Luxembourg/Amsterdam Frankfurt/Paris Zürich/Brussels Others

Analysing each category separately, the authors found that London’s ability to attract foreign capital and professional expertise gave it an excellent rating for factors of production (A). The attraction of foreign capital was also regarded as a particular strength for Luxembourg. In the area of man-made environment (B) London showed special excellence in diversity and size of markets, international, and innovation. The importance of banking activities and technology were also considered to be outstanding. Both Zürich and Luxembourg were praised for political stability, banking activity and bank secrecy. This pattern continued through the last two groups of characteristics. London’s dominance again manifested itself with regard to the regulatory framework (C) where its strength rests on the deregulation of money and capital markets. The latter gave Luxembourg, too, an advantage over other financial centres. In the final category of fiscal regulation (D) London and Luxembourg again lead other centres. London’s excellent rating is mainly based on transaction costs and commissions, whereas Luxembourg benefits from the absence of a withholding tax (Abraham et al. 1993: 22). To underline their findings Abraham et al. compare their study to an earlier survey by the French Centre d’Observation et de Prospection Sociale (COPS). In Table 3.8A Scores for main centres1

London Luxembourg Frankfurt Paris Zürich Brussels2

A

B

C

D

Total

1.95 2.67 2.63 2.74 2.73 2.63

1.59 2.65 2.66 2.44 2.54 3.30

1.44 1.94 2.28 2.26 2.42 2.60

1.73 1.77 2.29 2.57 2.83 3.11

1.69 2.28 2.48 2.52 2.64 2.91

1. Rating 1 = excellent; rating 5 = very bad. 2. Brussels was evaluated in both studies. The different results are mainly due to a change in the constitution of the panel, not to changes from one year to the next. Table 3.8B Scores for medium sized centres

Brussels Amsterdam Copenhagen Madrid Milan

A

B

C

D

Total

2.99 2.38 3.26 3.16 3.08

2.99 2.33 3.28 3.12 3.35

2.40 2.25 2.64 3.07 3.19

2.99 2.48 2.95 3.05 3.30

2.77 2.36 3.03 3.10 3.23

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The future of European financial centres

1986 the Centre asked 1,000 institutional investors and business executives in the Benelux countries, France, Germany, the UK and Switzerland about their views on the financial centres of Brussels, Frankfurt, London, Luxembourg, Paris and Zürich (Abraham et al. 1993: 24). The two rankings are summarised in Table 3.9. The dominant position of London is highlighted by both studies, though the gap between London and its closest pursuer is substantially smaller in the COPS survey. In both cases Frankfurt is ahead of Paris, and Brussels is ranked as the weakest financial centre. Luxembourg’s importance, however, seems to be given a significantly different weight by the panel members of the Abraham et al. study, and by the participants of the COPS inquiry. The explanation Abraham et al. (1993: 25) forward for this observation is that they had a relatively large number of Belgian panel members ‘who are sensitive neighbours of the Luxembourg IFC’27. In addition, Abraham et al. looked at medium sized centres, the rankings for which are presented in Table 3.8B. The scores for these centres cluster around three which gives them an average rating that is significantly less than the one for main centres. The obvious exception is Amsterdam, which not only leads in the category of medium sized centres but outperforms most of the main centres. It obtains a substantially better ranking than Frankfurt, Paris and Zürich. The authors report that Amsterdam has been ranked ‘excellent to rather good’ for 33 out of 47 criteria (Abraham et al. 1993: 54). According to the evaluation of the panel members its main strengths are the absence of capital controls, a stable currency, the absence of inflation, presence of multinationals, attitude towards innovation, political stability, availability of sophisticated financial instruments, and the functioning of markets for options. Amsterdam obtained its weakest ratings for the absence of important international institutions, and for bank secrecy. From this, Abraham et al. concluded that three sets of factors determine success or failure of a medium sized financial centre. These are: • • •

Political and macroeconomic stability Financial organisation Customer base for corporate and institutional banking

The main result of Abraham et al., the undisputed leadership of London, is underlined by the information provided in Table 3.10. Here we used the findings from Tables 3.8A and 3.8B respectively to rank financial centres by the placings they obtained in the four categories without regard to the weighting of those criteria. A centre was given one point for first place, and ten points for tenth place. The centre with the lowest number of points was then ranked first and so forth. The outcome is highly similar to the results presented by Abraham et al. London scored first places in all four categories, and is very much in a league of its own. Amsterdam and Luxembourg switched places but their scores are so close to each other that again they might be paired into one group, followed by Frankfurt, Paris and possibly Zürich. Frankfurt again comes out, just, in front of Paris. In this unweighted ranking Zürich’s score,

On the optimal design of an international financial centre

37

Table 3.9 Comparative ratings1 Abraham et al. (1993)

Score

COPS (1986)

Score

London Luxembourg Frankfurt Paris Zürich Brussels

8.35 6.92 6.38 6.29 5.96 5.24

London Frankfurt Zürich Paris Luxembourg Brussels

7.89 7.25 6.97 6.67 5.89 5.62

1. Ratings: 0 = minimum; 10 = maximum.

Table 3.10 Ranking by unweighted placings A

B

C

D

Overall

London Amsterdam Frankfurt Luxembourg Brussels1 Zürich Paris Milan Madrid Copenhagen

London Amsterdam Paris Zürich Luxembourg Frankfurt Madrid Brussels Copenhagen Milan

London Luxembourg Amsterdam Paris Frankfurt Zürich Brussels Copenhagen Madrid Milan

London Luxembourg Frankfurt Amsterdam Paris Zürich Copenhagen Brussels Madrid Milan

London (4) Amsterdam (11) Luxembourg (13) Frankfurt (17) Paris (19) Zürich (22) Brussels (28) Madrid (33) Copenhagen (34) Milan (38)

1. In the original study Brussels is ranked twice. Once for main centres, and again for medium sized centres. Here we added both scores, and took the average to arrive at one value and therefore one placing for Brussels.

however, is closer to that of Frankfurt and Paris than to Brussels’. Madrid, Copenhagen and Milan form the weakest group in both approaches.

The IfK questionnaire The results of the IfK survey are presented in the order of the questionnaire as described earlier in this chapter. First, foreign banks were asked why they had chosen the locations of London, Frankfurt or Paris respectively. The main reasons given in favour of London were that the city is an international financial centre with the presence of a large number of leading international financial institutions and customers. Its diversity of markets was regarded as superior to other centres, London’s predominance in the euromarkets was particularly stressed as a favourable factor. In this context the size of transactions and comparably liberal banking supervision were listed as advantages. Respondents pointed out that the presence of several markets and market participants, as well as highly developed modern technology made London an information centre. Other

38

The future of European financial centres

criteria like infrastructure, professional expertise, supporting services, time zone, and language were thought to be best fulfilled in this location. London’s tradition as a financial centre, and the geographical closeness of market participants in the square mile are two other factors that were frequently mentioned. Interviewees found Frankfurt an attractive location due to the economic framework and industrial structure in Germany. They pointed to Germany’s role as a major trading nation with an important currency, and thought it likely that Frankfurt might benefit substantially from German unification. Non-EU banks in addition regarded Frankfurt as an ideal base to gain access to the single market. Other factors in Frankfurt’s favour were advantages arising from the universal banking system, the establishment of the futures and options exchange, or Deutsche Terminbörse (DTB), which enabled traders to hedge their risks, and customers’ expectations that their banks should be present in Frankfurt. Many foreign banks chose Paris because they already had a well developed branch network that made a penetration of the French market easier. The deregulation in the 1980s was frequently considered to ease market access in general and to increase the likelihood of profitability, i.e. off-balance sheet transactions. Respondents stressed Paris’ potential for new products, its positive attitude towards innovation, and a flexible banking supervision. They found a strong international orientation at this financial centre with almost all financial products on offer. Therefore many interviewees regarded Paris as a supplement or even an alternative to London. This view was underpinned by the fact that Marché à Terme International de France (MATIF), the French futures and options exchange, was the third largest exchange of this kind in the world, ahead of London. Other reasons for moving to Paris were that banks followed their international customers, and that an address in the city was perceived as being very prestigious. Second, the IfK researchers tried to evaluate which centre – London, Frankfurt or Paris – domestic banks would choose if they had to decide between those three locations. Respondents in London were largely indifferent between Frankfurt and Paris. The main arguments for and against both sites are presented in Table 3.11. Interviewees in both Frankfurt and Paris were unanimously in favour of London as a location. The main reasons for this decision are summarised in Table 3.12. Despite this clear vote for London, some positive views on Frankfurt were voiced in Paris. Frankfurt is regarded as an important national and international financial centre which shows great potential for further development. In particular the strength of the DM and the size of the economy were mentioned as additional positive factors. It was expected that the city could play a more global role if a thorough deregulation were envisaged. The only argument respondents in Frankfurt put forward in favour of Paris was the strength of its investment saving. Third, the second question of this first part of the survey dealt with the most important criteria for a European financial centre. Respondents in London and Paris agreed on the following factors: diversity, liquidity and transparency of markets, positive attitude towards innovation, a large number of market participants, flexible banking supervision, deregulation, presence of supporting services, economies of

On the optimal design of an international financial centre

39

Table 3.11 London views on Frankfurt and Paris Frankfurt

Paris

• • • •

• Good at selling themselves as financial centre • Determined to attract foreign banks • Efficient money market • Market easier to penetrate • Flexible banking supervision • Positive attitude towards innovation i.e. derivatives • Faster deregulation • Modern trading system

• • • • • •

Importance of DM Size and importance of economy Economic stability Unification and easy access to eastern European markets will lead to surge of international banks Strength of bond market Relationship banking makes market access difficult Banking supervision is too technocratic and conservative Trade is dominated by big banks Minimum capital requirement makes business too expensive Fragmented market

Table 3.12 The strengths of London Views in Frankfurt

Views in Paris

• • • • • • •

• • • • • • • • • •

Tradition International financial centre Liberal banking supervision Language Transparency and liquidity of markets Professional expertise Presence of international financial institutions

Tradition International financial centre State of deregulation Language Transparency, depth and width of markets Professional expertise Presence of international financial institutions Importance of euromarkets Positive attitude towards innovation Large scale of financial instruments

scale, professional expertise, a stable political and economic system, as well as low transaction costs and commissions. In addition, interviewees in Frankfurt and Paris believed in the necessity of a strong currency, a fair and efficient legal system, free market access and confidence in markets, and a supporting national market. Many respondents pointed out that there may well be several European financial centres, although London would maintain its leading role for the foreseeable future. Fourth, the question about the relevance of the ECB location was raised. Overall, 38 participants expected Frankfurt to become the site for a future ECB28, 16 thought it might be London, while six respondents believed the ECB would be established in Paris. Several other locations were mentioned as well. Luxembourg, Brussels and Strasbourg were chosen 25 times, while other cities like Amsterdam, The Hague, Basle and Berlin were named by 27 interviewees29.

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The future of European financial centres

In the opinion of those interviewed in London, being the site of the ECB has no appeal to other banks nor will it attract any other business. Even though hosting the central bank might have a psychological advantage it would not have the kind of spill-over effect that would make a city like Strasbourg or Brussels become an international financial centre. The main argument put forward to support this view was that in countries like Canada, Australia or the United States the site of the central bank and the respective financial centre are at different locations. About 50 percent of those interviewed in Frankfurt believe the location of the ECB is an unimportant factor for a financial centre and has only a psychological effect. They argue that it might increase the visibility and thus the reputation of a financial centre without replacing the necessary framework. One-third of interviewees reckon that this is sufficient for a definite comparative advantage. Only one-quarter of those asked expect the ECB to have any impact on its host financial centre. Interviewees in Paris assume that the monetary policy of the ECB will be executed in a decentralised manner. Therefore they expect almost no change concerning order and importance of the existing financial centres. There is an unanimous agreement that the location of the ECB is more a matter of political prestige rather than of practical use. Finally, respondents were asked to weight 27 criteria on a scale from unimportant (0) to very important (7), and to indicate which of the three financial centres – London, Frankfurt and Paris – performs best in each category. Table 3.13 reproduces the ten criteria that were considered most important at each of the three locations30. London leads the ranking of the three centres by a wide margin. It was ranked best 17 times, second five times and third five times. Frankfurt (8) came out ahead of Paris (2) with regard to first ranks, but was also ranked third (11) more often than the latter (9). Using the same method as in Table 3.10 where centres were given points according to their placings31 yields the result that London (42) is far ahead of Frankfurt (57) which beats Paris (61) into third place. Summarising we can say that the study underlines London’s role as leading financial centre in Europe, with Frankfurt and Paris competing for second place whereby Frankfurt is just ahead of the latter.

An analysis In the following we compare the results of the three studies presented in the previous section. This is of particular interest considering the time frame. The IfK study dates back to 1990 whilst Abraham et al. completed their surveys in 1991 (for main centres) and 1992 (for medium sized centres), and our own questionnaire survey was conducted in 1996. Taking the COPS survey of 1986 into account we can analyse a period of no less than ten years. This will give us an opportunity to estimate whether the relative importance of individual financial centres has changed over a time span that covered substantial changes in the working of financial markets,

On the optimal design of an international financial centre

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Table 3.13 The most important criteria for financial centres

1 2 3 4 5 6 7 8 9 10

London

Frankfurt

Paris

Telecommunications Foreign institutions Professional expertise Liquidity Political stability Deregulation Back-office activities Currency convertibility Transparency Stock exchange

Currency convertibility Liquidity Political stability Telecommunications Deregulation Economic stability Professional expertise Product diversity Transparency Stock exchange

Currency convertibility Liquidity Political stability Economic stability Stock exchange Foreign institutions Transparency Deregulation Professional expertise Product diversity

and the implementation of the European single market. Based on this analysis, and our findings from Chapter 2, we can then design an optimal financial centre.

A comparison of results The key questions which have been addressed in all four surveys are those about the most important characteristics a financial centre has to display in order to be regarded as an international centre, the relative positions of European centres, especially London, Frankfurt and Paris, and the reasons for the dominance of the former. Abraham et al. categorised the main criteria for the competitiveness of an international financial centre into four groups32. According to the weightings which they attached to each category, factors of production are more important than the man-made environment which in turn is more relevant than fiscal regulation. Market regulation is regarded as being of relatively low importance. Our own findings in the 1996 survey indicate a different picture33. Respondents consider the man-made environment to be more important than factors of production. They point in particular to the relevance of the special characteristics of the respective financial market, like the diversity and size of markets and the volume of transactions. As far as the regulatory framework is concerned we also obtain a result that is contrary to the weighting of Abraham et al. In our study respondents attach higher importance to market than to fiscal regulation. The latter, fiscal regulation in general and commissions in particular, are only ranked 19th and 16th respectively out of 23 criteria. The findings of our 1996 study are reinforced by the IfK results34. However, the different importance attached to the characteristics of financial centres has no influence on the overall ranking35. All four studies show that London is the leading financial centre in Europe and that its lead is quite commanding (see Table 3.14). Another feature all studies have in common is the superiority of Frankfurt over Paris. The COPS, as the earliest of the four surveys, has Frankfurt and Paris separated by Zürich whereas Abraham et al. find that Luxembourg is regarded as the second most attractive location ahead of Frankfurt and Paris, and our own

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Table 3.14 Comparative ranking COPS London Frankfurt Zürich Paris Luxembourg Brussels

Abraham et al. 7.89 7.25 6.97 6.67 5.89 5.62

London Luxembourg Amsterdam Frankfurt Paris Zürich Brussels Copenhagen Madrid Milan

1.69 2.28 2.36 2.48 2.52 2.64 2.77 3.03 3.10 3.23

IfK

1996 survey

London 42 Frankfurt 5 7 Paris 61

London 32 Frankfurt 19 Paris 7 Amsterdam 7 Luxembourg 6 Dublin 5 Milan 3 Zürich 3

survey sees Paris competing for third place with Amsterdam and Luxembourg. The results of the IfK study, which only considers the three locations of London, Frankfurt and Paris, points to a competition between the latter two with Frankfurt having the upper hand. Comparing the differentials between London and Frankfurt on the one hand, and Frankfurt and Paris on the other hand, it seems that in both the COPS and our own survey Frankfurt and Paris are almost as far apart from each other as London and Frankfurt, whereas the two studies conducted in Abrahams et al and IfK indicate that Frankfurt and Paris are in close competition36. However, we should not place too much weight on these figures as they might simply be due to variations in size as well as composition of the samples in the four studies. The important insight is that in Europe, London is in a league of its own as a financial centre, that Frankfurt is regarded as a slightly more attractive location than Paris, and finally that Luxembourg and Amsterdam are forces to be reckoned with. This leads us to the question why London is in such a dominant position. A look at Table 3.637 tells us that among the ten most important characteristics of London as a financial centre in our own 1996 survey are seven that are also regarded as being the most important criteria for the competitiveness of any financial centre. This is fully in accordance with the IfK findings38. The ten most important criteria for the success of a financial centre are almost identical with our own, and respondents expressed the view that London was superior to other locations mainly due to these criteria. A further similarity is the significance attached to the factor ‘financial tradition’. Both studies show that overall this is not an important characteristic for a financial centre. In the 1996 survey this criterion is ranked tenth, in the IfK study it is not mentioned at all among the top ten factors that are regarded as a precondition for a location to attract business. However, in the case of London, financial tradition is of particular importance. Since neither survey covers the reasons for this apparent contradiction we have to turn to the preceding chapter for an explanation. There we showed that London became the world’s first truly international financial centre, and that it has been the

On the optimal design of an international financial centre

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only European centre to be in that position. It was the first host to the eurocurrency markets, the first major country to abolish exchange controls, and the first country with a radical stock exchange reform. Hence it can be argued that London has historically been at least one step ahead of other financial centres, especially European ones, and is therefore regarded as being the location with the longest standing tradition. We have also extracted the relevance of sunk cost39 for financial firms which indicates a certain amount of inertia, meaning that firms once they have established themselves at a location tend to stay there. Thus, there is the possibility that some respondents did not necessarily have the tradition of London in mind when answering that particular question but rather thought about their institutions’ traditional base in London. A further argument, which cannot be derived from any of the four surveys but from Lazar’s (1990) sociological analysis of the attitudes of those working in financial markets, is that people involved in finance have by and large rather conservative views. This could be taken as a further indication of why they value London’s tradition as an important asset for the city. Having discussed the reasons for London’s strong position, we should also consider the views on Frankfurt and Paris. Table 3.1140 presents a summary of the IfK results for this issue. It shows the views respondents in London hold on those two locations. The main difference to be extracted from the findings is that Paris is seen as a very dynamic, even aggressive, and innovative marketplace whereas Frankfurt’s strengths are mainly derived from its position as the major financial centre of one of the most successful and stable economies. An analysis of the comments respondents made in our own 1996 survey41 indicates that Frankfurt has a reputation for being too complacent and not innovative enough. Factors like market size, the state of (over)regulation, the quality of human resources and the less international orientation were pointed out. Moreover, Frankfurt is perceived as a particularly dull and unattractive city. In contrast, respondents found Paris, like some other European cities, a very attractive location. Reinforcing the IfK findings, they also stressed that of the two, Paris is by far the more aggressive and determined market. However, the most striking result is the agreement that by and large London is in a league of its own.

The time frame The four surveys cover the period 1986 to 1996. The two major events during this time as far as financial services are concerned are the Big Bang, meaning a substantial reorganisation of the financial centre in London, and the implementation of the European single market programme. As noted above, the relative positions of the financial centres of London, Frankfurt and Paris have not changed during the decade. London has no reason to fear competition from any other European location, Frankfurt is ahead of Paris which in turn has to fend off Luxembourg and Amsterdam. This leaves us with the question how respondents view the impact single market regulation has had and will have on the competitiveness of European financial centres.

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Our own 1996 survey is the only of the four studies which explicitly deals with this issue42. We asked respondents whether they believe that European regulation on financial services has a positive impact on the competitiveness of European financial centres, and which location they expect to gain most43. The results show that EU regulation is mostly regarded as being positive. Respondents think that the harmonisation of financial services throughout the Union strengthens European financial centres though not all centres will gain equally. It is expected that Frankfurt will emerge as the main winner of the single market legislation in the financial sector. We know from answers to earlier questions44 that many respondents find Frankfurt comparatively over-regulated. From this we may conjecture the argument that Frankfurt will find it easier to adapt to the new European regulatory framework simply because it has less to adapt to. On the other hand, liberal centres like Luxembourg stand to lose the comparative advantage they gained due to the state of national deregulation. The harmonisation process will also force Frankfurt to overhaul some of its features that are regarded as particularly negative like the market domination by the big banks. Thus, the location may become relatively more attractive whereas at the same time some financial centres which are now very popular due to some specific and lowly regulated activities will become relatively less attractive. However, we should not ignore that there is a substantial number of respondents who believe that EU regulation of financial services is rather harmful to Europe’s competitiveness at an international level. They point out that finance is a global business, and that the, in their view, over-regulated European market is not in a position to compete internationally. Here we have to recall two results that emerged from the responses given to some other questions. First, our analysis of all four studies shows that the specific characteristics of a financial centre become more and more important, and that investors are happily prepared to spread their business over several locations according to their attractiveness in certain areas. As we will show in the following chapter, EU regulation still leaves some scope for financial centres to develop those special characteristics. Second, our sample contains a large number of non-European institutions which, despite the regulatory framework imposed by the single market, state that they see no alternative to London as a financial centre, both within Europe and at the international level. On the one hand, this could be taken as an indicator that a strong, well developed location will not be harmed by European legislation. On the other hand, however, this may be further proof that London is considered as an international financial centre whereas all other centres compete for the position of leading European centre. Overall, we can summarise that according to our questionnaire survey the regulatory changes over the past decade have not influenced the relative standing of European financial centres. London still leads by a wide margin, followed by Frankfurt ahead of Paris. Our analysis has also shown that London is regarded as an international centre whereas all other locations are European financial centres. Furthermore, for reasons discussed above, it is expected that Frankfurt will gain most from the single market regulation in financial services.

On the optimal design of an international financial centre

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The design of a competitive financial centre As we have shown in the preceding chapter, financial centres historically developed in port and trade centres to finance trade. In order to become an international financial marketplace it was necessary to have an internationally acceptable currency, a satisfactory level of savings combined with the ability to export capital, a full range of developed markets, access for foreign institutions, political and economic stability as well as the availability of skilled staff and supporting services. In addition, Revell (1994) points to the importance of flexible prudential regulation45, market orientation (as opposed to bank orientation), and a legal community used to deal with financial and commercial cases. Over the centuries, and indeed the past decade, the working of financial markets has changed substantially. We have observed stock market reforms in many countries following the 1986 Big Bang, the abolition of capital controls, and the implementation of the European single market. Hence, some of the factors that were initially considered of major importance for the success of a financial centre apply no longer. Others, however, as indicated by the four surveys we have analysed in this chapter, are still valid. In the following we will consider the present significance of the factors that were historically of importance for financial centres, and compare the result to the findings from the surveys. A strong currency is not of particular relevance for a location in order to attract international business. The most prominent example here is London. Sterling lost its importance as a world currency long ago, yet the city’s success demonstrates that it is possible to thrive on the back of a foreign currency, namely the US dollar. This is underlined by the findings of the 1996 survey in particular which shows that the strength of the national currency is only regarded as the 15th most important criterion out of a list of 23 characteristics for a financial centre. Liquidity is still considered to be of great importance, in fact in both the IfK and our study it is among the top ten criteria for the choice of a location. This comes as no surprise as any financial business is essentially based on the availability of capital. The ability to export capital, however, has become an altogether irrelevant factor, as all major countries have abolished capital controls. A full range of developed markets is still one of the most important characteristics of a successful financial centre. In the 1996 survey it was ranked second only to human resources, another criterion that has lost none of its relevance. The same is true for the presence of international institutions, mainly banks, which has been of great importance historically and is among the five most significant factors that determine the position of a location according to our questionnaire survey. Political and economic stability, however, are not a top priority any longer. This should not be interpreted as if these two factors are of no concern for financial institutions but rather that all major locations guarantee both political and economic stability and have become identical with regard to these issues. They are factors which are taken as given in any of the financial centres considered. In summary we can note that for a location to become an international financial centre the following factors are of utmost importance:

46 • • • • •

The future of European financial centres the availability of skilled staff and supporting services a full range of developed markets the presence of international institutions the state of market regulation a well developed infrastructure

As some factors have become identical for locations, e.g. political stability, and the free movement of capital, the specific characteristics of a financial centre such as human resources or the diversity and size of markets, have become decisive in determining the attractiveness of a location as an international financial centre.

Figure 3.1 Framework for a successful financial centre

Notes 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15.

A more detailed breakdown is produced in appendix A1. Ministry of Finance. See appendix A3 for details of the questionnaire. See appendix A4 for details of the questionnaire. See appendix A5 for details of the questionnaire. See appendix A6 for details of the questionnaire. We assume that governments will, at least officially, always state that their strategies are adequate. See appendix A7 for details of the questionnaire. See appendix B2 for details of the questionnaire. In London, the two alternatives were Frankfurt and Paris, and in Paris respondents could choose between London and Frankfurt. The list is reproduced in appendix B2. A more detailed breakdown of the responses by all four groups is given in appendix C1. We neglect central banks for the moment due to the low number of responses. As in the case of the glass that is either half full or half empty, we could of course state that they agree on half of the listed criteria. Due to the slightly different structure of their questionnaire, academics were not asked to specify their views.

On the optimal design of an international financial centre 16. 17. 18. 19. 20. 21. 22. 23. 24. 25. 26. 27. 28. 29. 30. 31. 32. 33. 34. 35. 36. 37. 38. 39. 40. 41. 42. 43. 44. 45.

47

This includes academics. See also appendix C10. This relates to the columns labelled I. Question three for banks/investment firms/financial consultancies; question two for all others. Together with several other criteria. Respondents could choose more than one location, therefore the individual figures exceed the total number of returns. The complete response to this question is reproduced in appendix C3. Which may or may not be the home country. See appendix C5. See appendix C7. See appendix C8. IFC = international financial centre. We know meanwhile that they were right and the ECB will be established in Frankfurt where the European Monetary Institute is already working as a transitory institution. The remaining 15 respondents gave no answer to this question. For a detailed presentation of these results see IfK (1990). One point for first, two for second, and three points for third place. See ‘The Abraham et al. Panel Study’. See Tables 3.3 and 3.4. See Table 3.13. We calculated the Abraham et al. results according to the 1996 and the IfK surveys. The unweighted rankings for Abraham et al. are shown in Table 3.10. The differences are for the COPS 0.64 for London and Frankfurt, and 0.58 for Frankfurt and Paris; for Abraham et al. they are 0.79 and 0.04 respectively; for the IfK 15 and 4; and for our own study 13 and 12. See ‘The 1996 Survey’. Tables 3.11 and 3.12. See Chapter 2, ‘A Location Theory Approach’. See ‘The IfK Questionnaire’. This refers mainly to questions 3 and 5 for banks/investment firms/financial consultancies. The IfK questionnaire only covers attitudes regarding relevance and expected location of the ECB. Question 5 for academics, question 6 for governments and central banks, question 7 for banks/investment firms/financial consultancies, and question 8 for exchanges. See also appendices C7 and C8, and ‘The 1996 Survey’. See appendix C3. We will discuss this issue in the following chapter on financial market regulation.

Appendix 3.1: Desirability bias Olsen (1997) studied what he calls the desirability bias among professional investment managers. Desirability bias is defined as the tendency to overpredict desired and to underpredict undesired outcomes. His analysis is based on two observations. First, previous research indicates that non-experts have a very intense bias while professionals display little evidence of it. Second, both academics and investment managers claim that financial markets are efficient and thus bias-free. Olsen proposes to identify empirically the extent to which wishful thinking impacts on the forecasts made by professional investment managers with regard to potential economic events. He therefore conducted two studies. The sample of the first comprises 106 US Chartered Financial Analysts who participated in a mail survey.

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For the second study, 40 Taiwanese investment managers enrolled in an executive development program were chosen. Both studies show that professional investment managers, too, are characterised by a desirability bias1. However, some qualifying remarks are in order at this point. The average degree of bias is not very pronounced. It might therefore be argued that although some managers exhibit an intense bias, unbiased agents will arbitrage away this impact. Nonetheless, in the short run bias can lead to poor investment performance. Furthermore, it should be noted that the degree of bias increases with the importance of an event. Intuitively it appears logical that investors are more likely to ask for professional advice on occasions of importance. Hence, the bias may have the strongest influence when objectivity is most desirable. In situations with a probability close to 50/50 even a small amount of bias can easily tip the balance one way or the other. While it is difficult to take the results of one empirical study and use them as an explanation for the results of a completely different survey, some issues are rather suggestive. Comparing Olsen’s findings to those of our 1996 survey one might ask the following questions: • • •

Is London’s substantial leadership to some extent due to bias? Could desirability bias explain why Frankfurt is ranked higher overall than Paris although the latter appears to display more and stronger positive attributes? Is the great importance attached to human resources maybe due to the desire of respondents for themselves to be more valuable than any other factor?

Unfortunately, we cannot answer these questions here. The 1996 survey was not designed to yield a behavioural profile of respondents. Nonetheless, it seemed worthwhile to look at the issues involved from a different angle which offers scope for future research.

Appendix note 1. The special characteristics of both samples and the design of the surveys is described in Olsen (1997).

4 The rules of the game: Regulation of financial services

In Chapter 3 we have shown that regulation is not regarded as one of the most important criteria for the success of a financial centre. However, different groups take different views on the topic. It appears that governments and central banks place higher relevance on regulation than say investment bankers. Nonetheless, whenever there is a crisis in financial services, such as the collapse of Barings Bank, much of the ensuing debate focuses on the issue of regulation. Thus, in this chapter we will analyse European and international regulation, its objectives, and the different forms it can take. We will pay particular attention to the way the EU attempts to regulate Europe’s financial markets. This discussion will be rounded off with an outline of some particularly contentious issues such as the balance between regulation and deregulation, the role of technology, and the use of financial derivatives.

An overview We start by comparing the European framework to international attempts at regulating financial services. After discussing the regulators we will outline their main objectives, and the types of regulation they have at their disposal. Having covered the topic in a general context we then turn to EU legislation which aims to create a single market for financial services. We consider the major directives in banking, insurance and securities as outlined in the European Commission’s White Paper. In the final part of this chapter we assess the impact the directives may have on the competitiveness of financial centres in Europe, and analyse some of the key issues in international finance such as the impact of information technology (IT), financial innovation, and the increasing globalisation of financial services1.

European and international regulation The financial services industry is characterised by high mobility of its factors of production. Therefore, the scope for national authorities to regulate financial markets is limited. Essentially, there are two main options. Countries can agree to harmonise

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The future of European financial centres

their national standards, or they can establish a supranational supervisory body2. Whichever way they choose, they have to accept that regulation in this area has to show an element of dynamics in order to enable regulators to respond efficiently to changes in the markets. New products and investment strategies may not be covered by existing regulation. Regulators will have to move fast and competently to capture new developments. In addition they are faced with Goodhart’s Law which stipulates that those who are regulated will tend to find ways around the regulations that are applied to their trade. In order to draw up uniform rules, countries have to organise themselves. With regard to financial services the main international regulatory bodies are the EU, the Basle Committee, and the International Organisation of Securities Commissions (IOSCO). The Basle Committee, or more precisely the Committee on Banking Regulations and Supervisory Practices, is made up of the Group of Ten3 plus Luxembourg and Switzerland. The main achievement of the Basle Committee is the Basle Accord of 1988. After many years of discussion it outlines an agreement on uniform rules for capital ratios. One of the major problems the Committee had to overcome was the definition of capital. It was finally decided to distinguish between Tier 1 and Tier 2 capital. Tier 1 consists of shareholders’ equity, retained profits, and non-cumulative perpetual preference shares. Tier 2 is made up of cumulative perpetual preference shares, revaluation reserves, and subordinated term debt. The agreed capital ratio is 8 percent, at least half of which has to be Tier 1 capital. In addition, risk weighting figures are attached to all assets. An unsecured loan for example has a risk weight of 100 percent, while cash carries a risk weight of 0 percent. The risk weight thereby indicates the probability of default. Risk weightings are also applied to off-balance sheet items such as loan guarantees and derivative instruments (Bank for International Settlements (BIS) 1991). The Basle Accord is designed to achieve international convergence on capital measurement and capital standards. It attempts to create a level playing field so that institutions are not put at a competitive disadvantage due to different levels of capital covering the same type of business in different countries. This approach should also ensure the soundness and stability of the international banking system. We will see later that some of the EC regulation, the Own Funds and Solvency Ratio directives, are quite similar to the Basle agreement. The IOSCO also discussed capital adequacy. When the IOSCO met in October 1992, it was hoped members would agree with the Basle Accord. However, the IOSCO proposal differs substantially from the Basle agreement. In fact, at its meeting in February 1993, the IOSCO decided to abandon any attempt at internationally uniform capital adequacy requirements (BIS 1994). With the adoption of the Capital Adequacy Directive (CAD) by the EU in 1996, there are now essentially three different standards in operation: the Basle Accord, the IOSCO rules, and EU regulation. We will now investigate why the latter regards it as necessary to have a separate regulatory framework. The European Community’s internal market programme started in 1985 with the Commission’s White Paper which was proposed at the Milan meeting. It was intended as ‘action to achieve a single market by 1992’ (COM 1985: para 2) and can be seen

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as the linchpin of the Single European Act (SEA) agreed at Luxembourg in December the same year. It defines the single market as ‘area without internal frontiers in which the free movement of goods, persons, services and capital is ensured’ (European Economic Community (EEC) Treaty: new article 8A (COM 1985)). The crucial component of the White Paper is its emphasis on mutual recognition of national standards. Under this principle a product has to be admitted to all member states once it has been approved for one market, and a financial institution has to be admitted to all member states once it has been authorised in one country. There are 25 financial services proposals in the White Paper which are ‘intended to promote competition, increase competitiveness and widen choice’ (COM 1992b). Right before the establishment of the single market, the financial services sector accounted for 7 percent of the Community’s Gross Domestic Product (GDP) (COM 1992b); in terms of employment it stood for 3.5 percent of total employment (Fitchew 1990). According to the Cecchini Report (Cecchini 1988; COM 1988b), which examines the cost of non-Europe, the integration of European banking, insurance and securities business will save the Community about European Currency Unit (ECU) 22 billion. The Cecchini Report might be criticised on several grounds. Since it was written for the Commission it may be biased and may overestimate the potential benefits of integration. Dixon (1991), Dudley (1993) and Henderson (1993), to name just a few, come to the conclusion that the findings of the Cecchini Report are based on over-optimistic assumptions. Henderson (1993: 16) in particular argues that it is inaccurate and fails ‘to examine the regional spread of benefits within the Community’. However, he too estimates that there will be substantial gains from completing the internal market which might well be between 4.3 and 6.4 percent of Community Gross Domestic Product (GDP). Price Waterhouse (1988) in their study on the cost of non-Europe simulate the impact on consumer surplus of the decrease in financial services prices to the lowest EC levels4. They assume a potential price reduction for the financial services sector of 7 percent5. The expected benefit from the liberalisation of financial services was estimated as being one-third of the overall macroeconomic gains achieved by completing the internal market. The essential point in this context is that even the most critical evaluations of the potential gains from establishing a single market in financial services expect considerable benefits. The EC relies to quite some extent on high capital-asset ratios to prevent an over-exposure by financial firms. Another reason for this regulatory approach might be the acknowledgement that a policy of liberalisation which is based on the harmonisation of essential requirements and mutual recognition should depend more on a few transparent and generally accepted rules and less on the discretionary powers of national authorities. Thus the EC has chosen high capital-asset ratios at the risk of a certain rigidity in the regulatory approach. It is expected that the effects of liberalisation will be felt more strongly in countries that had a heavily regulated banking sector and limited competition prior to the single market legislation, i.e. in southern European countries. Accordingly, Price Waterhouse (1988) estimated that the largest price reductions related to liberalisation

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The future of European financial centres

will take place in Spain and Italy with potential price reductions of 34 percent and 29 percent respectively6. Authors such as Grilli (1989), Vives (1990) and Neven (1989), however, disagree with this assessment. Grilli (1989) argues that most national markets have a relatively oligopolistic structure and important barriers to entry, mainly due to imperfect competition, extensive branch networks and a long established reputation of banks at local and national levels. The move towards a genuinely European market is thus expected to be a very slow process, especially in retail banking. Neven (1989: 2) supports this view by pointing out that ‘banking products are differentiated in the sense that consumers will not switch from one bank to another in response to small price differences’. Bigger effects of liberalisation are likely in terms of large deposits and specialised services provided to large firms which are supposedly more flexible in finding the cheapest provision of services required. The international dimension of the EC’s activities concerning transactions in securities was stressed in a joint declaration by the Vice-President of the Commission, Leon Brittan, and the President of the US Securities and Exchange Commission, Richard Breedan, signed in 1991. The declaration aims at improving the cooperation between the EC and the USA in the securities field. This may also be viewed as a response to John Redwood, then Trade Minister in the UK, who pointed out the danger of losses to offshore centres outside the EC such as Zürich: ‘[...] there is no economic law which states that the EC will always maintain a major financial services industry. Modern technology allows people to shift business around the world rapidly’7. After this introduction to financial market regulation we will now investigate the objectives and the forms of regulation in financial services.

Objectives of regulation Financial regulators are faced with the dilemma of striking a balance between market flexibility and investor protection. This is particularly difficult in times when the use of a financial instrument is growing exceptionally fast, and when due to this trend a large number of new investors enter the market. There is the inherent danger of less experienced players getting into serious difficulties, say through overexposure and/or inappropriate advice, with potential spill-over effects for lenders. Advances in technology and product innovation precede advances in the legal setting. A new product or investment strategy has to be developed before regulators can change or amend the laws governing the financial industry. Rarely can regulators be expected to anticipate innovations. However, assuming that badly designed products will either not enter the market or will be weeded out quickly, the regulatory authorities need not be concerned with every component of a financial instrument. Their obligation is to ensure the smooth and efficient working of the markets, and the adherence of market participants to existing regulation. Therefore, they have to direct their attention to the factors that guarantee the optimal operation of a regulated financial market: transparency, liquidity, security, market access, and supervision8. Essentially, regulators should prevent market failure, meaning any event which

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puts the safety of investors’ funds into jeopardy and destabilises the financial system9. Thus, the overriding objective for regulators is the avoidance of systemic risk. This is commonly known as the domino effect and refers to a situation where the failure of one financial institution triggers the collapse of others. The most thoroughly researched example is that of bankruns (Diamond and Dybvig 1983). Here, one bank is known to be in financial difficulties. As a consequence, its depositors get anxious about the safety of their funds and withdraw their deposits. If a large enough number of depositors withdraw their savings and other investments at more or less the same time, the troubled bank will run out of reserves. It will have to close down without being able to pay all its depositors. Once this information becomes public, as it eventually will, investors with other banks will become nervous about the safety of their deposits and thus decide to withdraw them in good time. A run on other banks will start until finally the whole system collapses. In the process not only ‘bad’ but also perfectly sound and healthy institutions will collapse. This example highlights how important it is to identify ‘bad’ institutions at an early stage and either prevent them from trading by refusing authorisation, improve their standards through regulation, or force them to close down. This in turn can easily have spillover effects into the entire financial system. Steil (1992: 66) concludes that ‘systemic risk is the market version of acid rain: it may be produced in only one jurisdiction, but its effects know no boundaries’. It appears that with the increase in financial conglomerates and innovation, evidence for systemic risk has also increased in recent years (Anderton 1995). The second major objective is for regulators to ensure market efficiency. A necessary condition for this is the existence of integrated markets to allow for arbitrage10. Arbitrage in turn creates efficient market prices. The wider the definition of integration, the wider the degree of efficiency and innovation (Steil 1992). This leads to increased competition among markets and trading systems. Finally, regulators should aim at fairness, which Kenneth Berrill11 defined as ‘protecting Aunt Agatha’. What he means by this is that small investors should have the same access, information, and protection as large, often institutional, investors. In summary, the main objectives of financial market regulation are the reduction of systemic risk, the enhancement of market efficiency, and the promotion of fairness in market operations. We will now discuss the different types of regulation that aim to enforce the above mentioned objectives.

Forms of regulation We can distinguish three types of financial market regulation: structural, prudential, and investor protection regulation. All three forms have the objective to stabilise the financial system by ensuring the soundness and safety of financial institutions, to safeguard the efficiency of markets in terms of both the services provided and the products traded, to protect investors, and to maintain the functioning of the

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payments system. Below, we briefly outline each type, starting with structural regulation. Structural regulation is concerned with the main types of activities which financial institutions are permitted to engage in. It sets out the conditions for the establishment of new institutions and the branching out of exiting ones. Thus, a high degree of structural regulation would severely limit the level of activities that financial institutions may pursue. On the other hand, if the regulators envisage greater competition among firms they will lighten structural regulation. The latter case, structural deregulation, has been observed during the 1980s and 1990s. Take the UK as an example. Building societies are now permitted to engage in retail banking activities. Banks have ventured into stockbroking and the sale of insurance policies, and so forth. As a consequence, the boundaries between different classes of financial institutions have been blurred. Prudential regulation refers to the internal management of financial firms mainly with regard to capital adequacy, solvency, and liquidity. It is thus concerned with the balance sheet of an institution. Rules governing capital, liquidity, and solvency are imposed in order to maintain public confidence that financial institutions are able and willing to meet their liabilities at any time. Banks for example are required to hold a minimum reserve of capital relative to their activities. The amount of capital is determined by the amount and type of assets which they own. Capital adequacy thus ensures that even if banks occur losses due to a fall in their asset values they still have enough capital to conduct their banking business. This principle is perhaps even more obvious in the case of building societies. They have to fulfil capital adequacy requirements in order to absorb mortgage arrears and default. Adequate capital, however, is not identical to liquidity. An institution may have the former, yet has not sufficient liquidity to meet its obligations on a day to day basis. Liquidity is usually measured as a ratio of total assets. Once an institution satisfies the regulatory authority that it has sufficient own funds it will be judged solvent. Finally, investor protection regulation is designed to protect investors from fraud, negligence and malpractice. This type of regulation takes account of information asymmetries between investors’ knowledge of a financial firm and the institution’s knowledge about its position. Thus, investor compensation or depositguarantee schemes are set up. Such schemes may, however, invite moral hazard. It is possible that a financial firm takes a greater risk than it otherwise would, knowing that if it succeeds it will make a profit while in the case of failure investors will be protected by the scheme. It is also worthwhile to notice that investor protection regulation overlaps with the other two forms of financial market regulation. Prudential regulation, too, protects investors from the insolvency of an institution, and structural regulation covers potential conflicts of interest if types of businesses are not separated. Any form of financial market regulation can be carried out through self-regulation, formal statute, or a combination of the two. Self-regulation means that the industry

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imposes an informal regulatory framework upon itself while formal statute relates to a statutory framework. In the remainder of this chapter we will analyse the legal setting which the EU has developed for financial services.

A blueprint for Europe’s financial markets The main areas covered by EU legislation on financial services are banking, insurance, and securities. In its White Paper the EC adopted an approach based on three principles: harmonisation of key prudential standards, home country control, and mutual recognition. On this basis financial institutions authorised in one member state are automatically admitted to trade in the whole Community. They are essentially equipped with a single licence or, as it is often referred to, a single European passport. In the following we will consider the regulatory developments in banking, insurance, and securities. The main directives are summarised in Table 4.1.

Banking By the time the White Paper was agreed, EC legislation was most advanced in the banking sector though the demarcation line between banking, securities, and insurance was becoming blurred. The main barriers to full freedom of establishment in banking were authorisation procedures, capital adequacy requirements and restrictions on foreign acquisitions. There were substantial differences between banking structures in the then twelve member countries. In France, Italy, Portugal and Greece publicly owned banks play a major role. The UK, Belgium and Luxembourg are more open to foreign competition than the rest of the Community, while we can observe a high degree of market concentration in some of the smaller countries (Dermine 1990). Tsoukalis (1993) points out that another important difference can be found in the activities undertaken by banks, whereby he distinguishes the universal model in Germany, France, Italy and the Netherlands, and a traditional model which excludes direct involvement in the stock exchange. The liberalisation process in the banking sector is based on three main elements which are the harmonisation of essential rules, mutual recognition, and the principle of homecountry rule. The latter means that the regulatory authorities of a bank’s home country are solely responsible for prudential control and supervision of all domestic and foreign branches of that bank. Even though this principle had already been adopted in the First Banking Directive of 197712, the lack of agreement on harmonisation prevented any significant progress in this area. It took the Community more than a decade to formulate a new, workable regulatory framework for the banking sector. In 1988 the Council adopted a Directive13 for the implementation of Article 67 of the Treaty of Rome, which promoted the unrestricted movement of capital. This new directive set the timetable and arrangements for the complete liberalisation of capital movements within the EC14. The abolition of capital controls was scheduled for 1 July 1990 and was met by all eight members concerned. Spain and Ireland had

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Table 4.1 The main EC/EU directives/activities in financial services Year Banking 1977 1988 1989 1990 1991 1992 1993 1994 1995 1996 Insurance 1973 1977 1979 1988 1990 1991 1992 1993 Securities 1985 1987 1989 1993 1994

Directive/activity

Implementation deadline

First Banking Directive Abolition of capital controls Directive on Own Funds Directive on Solvency Ratios Second Banking Directive Discussion Paper on Payment Systems Directive on Money Laundering Directive on Large Exposures Capital Adequacy Directive Directive on Deposit-Guarantee Schemes Post-BCCI Directive Directive on Contractual Netting

12/79 01/93 01/93 01/91 01/93

First Non-Life Directive Insurance Intermediaries Directive First Life Insurance Directive Second Non-Life Insurance Directive Second Life Insurance Directive Insurance Committee Third Life Insurance Directive Third Non-Life Insurance Directive Directive on Unfair Terms in Consumer Contracts

01/75 06/78 09/80 12/89 + 11/92

Directive on UCITS Directive on Mutual Recognition of Listing Particulars Public Offers Directive Directive on the Regulation of Insider Trading Investment Services Directive Euro-Listings Directive

10/89 + 01/90 + 04/91 06/92 07/95 + Free

12/92 01/94 12/95 07/95 07/96 06/96

12/93 01/94 + 01/95

+ indicates the earliest implementation deadline in those instances where some countries were given more time for implementation.

an extension to the end of 1992, while three more years were given to Greece and Portugal due to their balance-of-payments problems. In 1989 a triad of directives were adopted. The first, the Directive on Own Funds15 deals with some general principles concerning bank capital. It distinguishes between original own funds, meaning capital and reserves, which are included without limit, and additional own funds, meaning supplementary capital16, which are not to exceed the former. The insight that underlies this directive is that the size of own funds is an important orientation for regulatory authorities to calculate a credit institution’s solvency. Standardisation of such calculations is regarded as being essential for mutual recognition and home-country control.

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Second, the Directive on Solvency Ratios17 demands a weighted risk assessment of bank assets and off-balance sheet items, and sets up a harmonised minimum solvency ratio of 8 percent for all credit institutions. It is aimed at protecting both depositors and investors as well as to maintain the stability of the banking system, and is in line with the guidelines of the Basle capital adequacy agreement18. However, the most prominent of the three 1989 directives is the Second Banking Directive (SBD)19. It introduces a single banking licence which will enable any bank authorised by the appropriate institutions of a EC member country to provide crossborder services and to open branches everywhere in the Community. The directive’s annex lists a number of activities in which banks are allowed to engage. The list which is based on the model of the universal bank includes investment services but not insurance20. This new regulatory framework also foresees provisions of minimum capital for authorisation (ECU 5 million) and the continuation of business, control of major shareholders and of a bank’s participation in the non-banking sector21 as well as sound accounting and control mechanisms. Under the home-country rule the country in which the parent company is based is responsible for prudential control for all branches of a bank, including foreign branches. The authorities of the host country will share the responsibilities for the supervision of liquidity of branches in their country and for measures related to the implementation of national monetary policy. This new piece of EC legislation came into operation on 1 January 1993. It provides the framework for an integrated banking sector. As far as the permitted activities of banks are concerned, the Community adopted a more liberal approach by opting for the universal bank model22 rather than the US or Japanese approach (see Tsoukalis 1993). Home-country control will prevent any discrimination by national authorities against branches of foreign banks. The Second Banking Directive also outlines a reciprocity provision. Reciprocity here means that the exclusion of e.g. a Greek bank from Japan might force all other EU members to react similarly against a Japanese bank wishing to open a subsidiary in one of the member states. This form of self-protection towards third countries arises from the expectation that the enlarged single market will attract a large number of non-EU institutions. The reciprocity approach should ensure that Community institutions obtain equal access to outside markets. This issue was quite controversial when the directive was discussed. Countries like the UK and Luxembourg with a strong international orientation of their financial sectors were concerned about a potential loss of business. Measured as percentage of GDP the size of the financial sector in those two countries is more than double that of the EC average (Tsoukalis 1993: 126). Coming back to the above example, the exclusion of a Greek bank from Japan might force Britain to reciprocate and refuse permission for a Japanese bank to set up a subsidiary in the UK. This possibility was not appreciated by all members. In the final text of the Second Banking Directive reciprocity is defined in terms of ‘national treatment’23 of EC banks, meaning no discrimination between national and European banks in third countries, and ‘effective market access’24 in cases where discrimination has taken less transparent forms. The

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Commission has a mandate for direct negotiations with the government of the country concerned when the criterion of ‘national treatment’ is not observed; in other cases it has to wait for a Council mandate. However, within this setting the EC pushed ahead with liberalisation in terms of branches as well as the range of activities in which banks are allowed to engage. Price Waterhouse (1988) therefore assume an increase in interbank competition both cross-border and domestic. Vives (1990) and Neven (1989) dispute these findings. Neven in particular stresses that in banking economies of scope as well as economies of scale are limited. Both authors come to the conclusion that competition will be imperfect. According to Vives (1990: 5) this is ‘due to the presence of important economic barriers to entry, yielding on upper bound for the integration benefits lower than the competitive benchmark’. He predicts that banks will react to increased competition with mergers, acquisitions and cross-participation agreements. Following Vives, this implies that though integration will have a significant effect on banking it will not attain levels associated with competitive or ‘contestable outcomes’ (Vives 1990: 5). With the final aim of EMU emerges the urgency to improve payment systems. Transfrontier payments within the EU should be as rapid, cheap and reliable as those within a member state. The Commission therefore adopted a discussion paper on payment systems in the internal market25. It describes the standard practice for cross-border payments and proposes a framework for improvements. Its main concern are small and medium-sized payments for which the costs are frequently out of proportion to the amount transferred. The paper proposes an interlinking of national settlement systems, and points out that to achieve this objective cooperation from banks and supervisory authorities in each member state is needed. To assist it in its work to facilitate, speed up and reduce the cost of money transfers in the Community, the Commission set up two working parties. The first is composed of representatives of banks and central banks, the second of representatives of small and medium-sized firms, distributive traders and consumers. The latter is supposed to provide a link between financial institutions and consumers. In the wake of the BCCI collapse in 1991, the Commission proposed to make countries in which a bank is registered responsible for compensations to depositors in other countries in case one of their banks fails. This was at first only a recommendation26 but was later formalised as a directive27 requiring that all member countries belong to a deposit protection scheme, which is supposed to protect depositors and thus safeguard the stability of the financial system. Subsequently, and in addition to the Directive on Deposit-Guarantee Schemes, the so called PostBCCI Directive28 was implemented. It specifies the structural and operational transparency of banking groups, their supervision, and the disclosure of shifting assets between financial centres. It also considers the role of outside auditors, authorisation procedures, and share ownership in banking groups. In essence, the Post-BCCI Directive reinforces prudential supervision.

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Insurance With regard to insurance the White Paper intends to create a market where insurance can be bought on competitive terms Community-wide. As in every other area of financial services the overall strategy is threefold: harmonisation of the basic principles of supervision, mutual recognition, and home-country control29. In 1973 the Council adopted a directive on the taking-up and pursuit of the business of direct insurance other than life assurance30. It was supposed to coordinate provisions on the formation of non-life insurance undertakings and on financial guarantees required of such undertakings, namely solvency margins and minimum guarantee funds. Risk is classified by class of business, and distinguished as mass risk and large risk. The Second Non-Life Insurance Directive on the coordination of laws, regulations and administrative provisions relating to direct insurance other than life assurance31 laid down the rules for cross-border non-life insurance by larger companies, defined as those with a turnover of ECU 24 million or over 500 employees. Its purpose is to balance the needs of freedom of services and consumer protection and thus to break down the barriers between national markets. The directive defines large risks as transport risks, credit and suretyship risks (if linked to trade), fire and other property damage, general liability as well as pecuniary loss32. Mass risks are accordingly all other cases where a greater need for consumer protection is considered. While large risks benefit from home-country control in services for businesses, mass risks may be subject to a stricter control in the state of provision of services. Unlike the single licence in banking, this directive did not establish a common passport. Thus, the establishment of branches in other countries still requires the authorisation of the host country. Likewise, the Council has adopted two directives in the field of life assurance. By introducing the principle of specialisation by life assurance undertakings33, it prohibited such undertakings from carrying on life and non-life business simultaneously. The aim is to safeguard the respective interests of life policy-holders and non-life policy-holders. We assume that the underlying perception with regard to this directive is the danger that the non-life part of a business may find itself in financial trouble and may be tempted to borrow funds from the life side instead of raising outside capital. A segregation of life and non-life business thus strengthened financial security. The second directive in this area34 is on the freedom to provide services in life assurance. It distinguishes between contracts where the prospective policy-holder wants to take out life assurance in another member state on his own initiative, and all other life assurance contracts. This implies that when a person decides to enter into an assurance contract in another member state, consumer protection ceases to be a prior consideration. Hence, home-country control should be applied. In all other cases strict restrictions remain. Insurers can be required to apply for special approval, depending on local law, and policy terms may be proscribed. Since November 1995 the Commission has had to write regular reports to the European Parliament and the Council on the development in the life assurance

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market and on operations transacted under conditions of freedom to provide services. To assist the Commission in its work in the insurance field and to establish closer cooperation between national supervisory authorities and the Commission, an Insurance Committee was set up in 199135. This Committee is made up of representatives of the member states and is chaired by the Commission’s representative.

Securities Finally, we have a look at the regulatory framework for securities. As far as securities are concerned the White Paper is directed at providing securities and capital markets with a capacity large enough to meet the financial needs of Europe’s industry and to attract investors from all over the world. To satisfy the needs of both groups the Commission concluded that a European securities market system has to be created36. The approach to achieve a single market in securities is similar to that adopted in all areas of financial services. It comprises harmonisation of essential standards, mutual recognition, and home-country rule. Parallel with the work on liberalising capital movements exists a coordination of the conditions for admission of securities to official stock-exchange listing, and of the contents, scrutiny and method of publication of the listing particulars as well as publication of information by listed companies. The directive on mutual recognition of listing particulars to be published for the admission of securities to official stock-exchange listing37 specifies which authorities are competent to check and approve listing particulars when an application to official listing is made in more than one member state. In such a case listing particulars have to be drawn up in the member state where the issuer’s registered office is located. If it is not in any member state the issuer has to choose one. Additionally, the directive lays down the principle of reciprocal agreements with non-EC countries. Regarding the prospectuses for public offerings of securities, the Council adopted a directive38 to ensure the provision of full and correct information regarding transferable securities. It applies to securities which are offered to the public for the first time in a member state. The publication of information on major holdings with the aim to protect investors is laid down in the 1988 directive39. It states that when, after an acquisition or disposal of a holding, one person’s voting rights exceed or fall below one of the thresholds of 10, 20, 33.33, 50 or 66.66 percent, the shareholder has to inform the company about the percentage he holds within seven days. The company, in turn, has to publish this information. In 1989 a directive40 on the regulation of insider trading was implemented. It defines inside information as such information not being made public, having a precise nature, and being related to one or more issuers of transferable securities, or to one or more transferable securities, that could have a significant effect on prices if made public. The directive does not apply to transactions carried out in connection with monetary and exchange policy as well as management of public debt by member states or central banks. There is also the possibility for each member state to allow

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insider trading as far as transactions outside a stock exchange are concerned as long as no professional intermediation is involved. In the field of investment services the Council adopted two directives; one right in 1985, the second in 1988. The first41 is on Undertakings for Collective Investment in Transferable Securities (UCITS)42. The main objective of the directive is the coordination of laws governing UCITS to give unit-holders a uniform and more effective protection Community-wide. These companies have access to market units through a single licence. Ninety percent of the investments of a unit trust must be transferable securities listed on a stock exchange or other regulated markets, and all particulars have to be published regularly. The other directive in that area43 lays down special measures for certain investment by UCITS and is basically an amendment to the 1985 directive. It names minimum requirements for adequate risk spreading, the separation of trustees from managers and the specification of acceptable investments. The criteria which determine whether or not a unit trust or any other fund falls within the definition of UCITS rule out a number of funds from being classified UCITS. Among these are money market and currency funds, property-based funds, investment clubs with restricted membership, close-ended funds, funds based on derivative instruments such as futures and options44, and many more. These funds can nonetheless operate domestically. In summary then, we have shown that the process to establish a single financial market is most advanced in the banking area. It is lagging behind with regard to insurance and investment brokers. This is basically due to the fact that bank regulations and operations have been relatively well coordinated globally45. The range of activities in investment services is much more heterogeneous than in the banking area. It has to be added that besides the unquestioned need for harmonisation, differences in national markets sometimes reflect differences in national preferences and circumstances. The three most ground-breaking directives for a single financial market in Europe are the SBD, the ISD, and the CAD. The SBD introduces the single passport and thus encouraged cross-border activities in banking. The ISD provides the same free trade EU-wide in its sector while the CAD links capital to market risk by requiring dealers to have a minimum of capital to back their transactions. The furthest reaching directives for insurance firms are the Third Life Assurance and the Third Non-Life Insurance Directives. Both are based on the single-licence principle and specify that marketing and selling practices are regulated by the country in which the insurance policy is sold. Having discussed the regulatory framework for financial markets in general and in particular, in the remainder of this chapter we will analyse some of the most prominent issues and debates arising from the regulatory setting.

Some issues We will start by addressing the balance between regulation and deregulation with special regard to the framework given by the EU. Following this general discussion

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we then discuss two of the most prominent issues in the globalisation process, namely financial derivatives and the role of information technology (IT). The chapter will be rounded off by an overview of past and likely future developments.

Regulation and deregulation We have shown the state of regulation in financial services at the international and the EU level. Despite the more or less precise directives adopted by the EU member states there still appear to exist several issues that need to be tackled in order to achieve a truly integrated financial market. Below is an outline of some of the adjustment problems in the banking, insurance, and securities areas. Let’s start with banking. One might criticise the White Paper on the grounds of fixing minimum capital asset ratios for banks46. Previously only Germany had exact legislation covering capital requirements. Usually the law demands a ration and gives the authority to set the precise figure to the supervisory body which can alter it if conditions change. However, if the minimum requirements were not laid down in a directive, the question of who should fix it would arise. A point connected to this is that the size of own funds and the solvency ratio are minimum standards. This enables individual member states to choose higher ratios. In that case, their banks would have to compete both domestically and internationally with institutions that are subject to less rigid standards. The same argument can be applied to the differences in activities permitted by national licences. Countries are free to distinguish between commercial and merchant banking although according to the SBD this is no longer necessary. By the same token, banks that have not obtained a licence for certain activities can nonetheless specialise in those areas by creating non-bank subsidiaries. A German bank can, for example, set up a subsidiary in Luxembourg and then operate branches in Germany under the conditions of the Luxembourg licence and supervision. The main problem in insurance is Germany’s protected market. Under national regulations a non-German insurance company is required to have a permanent local establishment. Furthermore, in commercial insurance there are rigid regulations on premium amounts which might be regarded as quasi-protectionism. Additionally, the German government has a monopoly on fire and property insurance as well as a health insurance system that differs from the rest of the EU (Tsoukalis 1993). One of the major problems in the securities area is to agree on capital adequacy rules for investment firms and credit institutions. The need for regulation in the securities market derives from ‘the combination of a highly competitive environment, associated declines in lending margins and risk premia, and a European-wide change in the regulatory regime [that] could create the kind of conditions [...] that in the past have led to financial instability’ (Dale 1992: 156). After much debate the Commission adopted legislation47 to harmonise the capital adequacy requirements for investment firms and to cover systemic risk. Banks and non-banks will thus be subject to equivalent legislation to ensure the same conditions for both groups and the free provision of investment services EU-wide regardless of whether investment firms are at the same time credit institutions. A further contentious issue in this area

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was the establishment of compensation schemes. Dale (1984) argues that depositguarantee schemes only provide for minimum protection, and that the public usually has very little information about the existence of the schemes. Let us briefly consider two areas without much harmonisation, namely taxation and the legal system. Disparities in the fiscal treatment of financial transactions, like levies on capital gains, withholding taxes on interest earned on government bonds by foreigners or stamp duties on securities transactions plus bank secrecy laws, hamper the full integration of financial markets. Different levels of taxation may easily be used to influence the location of investment. The full liberalisation of capital movements can lead to a large amount of transactions being directed towards the country with the most benevolent tax treatment. The potential consequences of such a scenario are asymmetric competition, tax arbitrage flows, and possibly a non-optimal allocation of resources. Investors may for example arrange for their investment income to be paid into a bank account outside their home country. Most EU members have the policy of not deducting tax at source or they exempt nonresidents, relying on them to honestly declare any income in their country of residence. This practice offers a loophole for tax evaders and avoiders and can lead to a significant revenue loss for governments. The Commission has made various proposals48 in this area. However, some countries, notably those with deregulated financial markets such as Luxembourg and the UK, fear that the imposition of this kind of regulation might lead to an exodus of international business to financial places outside the EU. Luxembourg in particular is highly protective of its bank secrecy (Tsoukalis 1993). Moreover, some countries operate tax systems encouraging savings and promoting types of investments which benefit the acquisition of domestic securities. The EU has not yet been able to establish a consensus to abolish this type of discrimination against foreign securities. Since the Council as the decision-making body has to vote unanimously on this matter, it might take time to reach a final decision. In order to solve the problem of tax evasion, Giovannini (1989) argues for a worldwide principle of taxation, meaning that residents are taxed on all their investment income no matter where the investment is located. Thus it would be possible to deal effectively with tax evasion and avoidance even under fully liberalised capital movements. However, the proposal assumes a high degree of cooperation among national authorities based on mutual trust and the abolition of bank secrecy laws. Although the proposal might be regarded as unrealistic and perhaps even naive, it received some support when the Belgian government appealed to the IMF for an international agreement on withholding taxes (Tsoukalis 1993). Nonetheless, much can be said in favour of Prest’s view that to expect an alignment of tax rates ‘this side of eternity’ is the same as ‘crying for the moon’ (Prest 1983: 37).

Financial derivatives Finally, let’s consider financial derivatives. The basic concept of a financial derivative is quite simple. Loosely speaking, a derivative is an instrument based on an underlying asset. Assume company X is quoted on the stock exchange. Its shares

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are then the underlying asset. An option to sell or buy company X’s shares by a future date at a given price (that is a price agreed today) is the derivative. Financial derivatives were initially developed to hedge risk inherent in transactions. Nowadays, they are increasingly used as yet another form of investment49. So called rocket scientists dream up more and more complex instruments every day, and even the most specialised professionals find it hard to follow every new development. The large number of (often tailor-made) derivatives enable users to cope better with fluctuations in exchange rates, interest rates, securities prices and so forth. They also offer increased opportunities for hedging and arbitrage between cash and derivatives markets thus leading to a deeper interdependence of markets. The flexible nature of financial derivatives has led to an explosion in over-thecounter (OTC) derivative contracts. OTC derivatives are traded between individual counterparties instead of standardised instruments traded on a recognised exchange. The IMF estimates that between 1993 and 1994 the value of OTC and exchange traded derivatives increased by 47 percent, and was greater than $12 trillion (IMF 1994: 10) which is about twice the nominal GDP of the USA. A recent BIS survey indicates that at the end of March 1995 the global OTC derivatives market was worth $40,700 billion with more than half of it based on foreign exchange rates and more than one-third based on interest rates (BIS 1996). Revell (1994) in addition points out that the amount in derivatives trade is often greater than the turnover in the underlying cash market. When the use of a (new) financial instrument is growing rapidly and many new players enter the market, there arises the danger that less experienced investors get themselves into financial difficulties. Depending on the magnitude of the risk they have taken, this then has potential spillover effects for lenders as outlined above. So how can or should a highly leveraged market such as the derivatives market be regulated? Bearing in mind what we said earlier about the speed of innovation in this area, regulators are hardly in a position to keep up with every new development nor can they be expected to understand every detail of a new product. Regulation of financial derivatives thus amounts to risk management, reducing the sources of systemic risk, and improving disclosure and accounting standards. This includes the practice that senior management is fully informed of the firm’s derivatives trading50. From the previous two sections of this chapter we know the state of international attempts to regulate this area of financial services. The EC extended its Solvency Ratio and Own Funds Directives of 1989 by adopting the CAD51 in March 1993. In accordance with this the Basle Committee put forward a proposal on new capital requirements for banks the following month. Its main innovations are the separation of banks’ loan and trading books and the isolation of market risk from specific risk. Banks are encouraged to take a portfolio perspective, which recognises that market risks of different securities are related. This approach allows for negatively correlated positions to offset each other. Furthermore, it is proposed that fixed-income derivative positions can be converted into combinations of simple debt securities for the purpose of computing capital requirements52 (IMF 1994). The Basle proposal applies to banks only. In most EU countries, however, banks perform the functions of

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securities houses. Thus, the proposal is relatively far reaching. Amending the Basle proposal, the EU formulated a new piece of legislation concerning derivatives: the Contractual Netting Directive which was adopted in 1996. It lays down capital requirements that take account of the credit risk inherent in OTC instruments, and aims to reduce credit and systemic risk in the derivatives markets53. This new directive requires member states to allow the supervisory authorities, when assessing the compulsory capital cover for credit risks from OTC derivatives, to take into account the risk reducing effect of types of bilateral netting agreements. Under these arrangements the different contracts included in the agreement remain legally untouched until close-out. Off-setting of the mutual claims and liabilities is triggered by the default of one of the counterparties54. From a regulator’s point of view these international agreements fulfil two purposes. First, they ensure that capital requirements capture all products55 and are based on measurement techniques that hold up in an environment with ever evolving markets. Second, they ensure that adequate safeguards are in place to capture the inherent risks even though they might be difficult to quantify. In addition, supervisory bodies are concerned with the disclosure of activities. The question here is what, to whom and how frequently information ought to be disclosed. The two main issues to consider are the fact that derivatives positions can change rapidly and frequently during short periods of time, and whether information should be disclosed to the regulators or the public. Some of these issues are taken up in the Fisher Report (BIS 1994) which was issued as a discussion paper by the Group of Ten central banks. It advocates the publication of quantitative information on firms’ market risk, hoping thereby to help counterparties as well as analysts to assess the quality of systems and controls.

The impact of technology From the above discussion we can conclude that the main reasons for the difficulties in regulating derivatives trading are the high leverage, the diversity of derivative instruments, and the volume of OTC trading. Derivatives markets like other financial market activities are enhanced by technological advances. When using the term IT we mean the integration of computing and telecommunications (hardware and software) which enables users to collect, process and exchange large volumes of information rapidly. Technological developments which are of relevance for financial markets are electronic mail, sophisticated telephone and computing systems, fax machines, image processing devices, communication satellites, and fibre optics. Recent progress in the area has been made through artificial intelligence, parallel processing, and silicon compilers. Computers using artificial intelligence can simulate human intelligence via the manipulation of symbols and decisions. This means that the machine can solve complex problems. A large number of computer operations can be conducted simultaneously through parallel processing, while silicon compilers are designed to integrate computer circuits. Other technologies that make global finance easier are automatic transfer machines, electronic sales points, telephone banking, interactive screen communications (between financial

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intermediaries and their customers), and the introduction of debit, credit, and smart cards56. Technology speeds up the completion of legal and business transactions, and decreases operation costs for firms. The rapid development in telecommunications and data processing has opened opportunities for continuous trading. Screen based trading encourages global trading more or less around the clock, and leads to a stronger interdependence of markets57 as outlined above. This makes it harder for the regulatory authorities to trace and control the prudent conduct of business activities. However, at the same time there is an increase in competition among financial centres and markets. The almost instant transmission of news throughout the world’s markets increases the speed of market responses to news. Foreign investors for example may not be impressed by a self-regulated ‘gentlemen’s club’, but want to be sure that transparent regulations are applied equally to all investors. Clarke (1986) argues that for this reason, regulation has to be formal, public and bureaucratic. In order to support his view he points to the increasing size of both transactions and markets, and the diversification of financial institutions. He also believes that the City of London’s tendency to deal with fraud internally has undermined the system of regulation through the lack of prosecution in cases of white collar crime. One might argue that advances in IT encourage globalisation. Investors are more aware of international opportunities, and financial markets become thus more dynamic, competitive, and efficient. Automated trading systems add to market usability, improved accuracy, instant information, and better handling capacity. The advantages of instant information for investors as discussed above apply also to regulators. Thus, IT offers improvements for supervisory authorities to identify and control risk. Having concentrated largely on the advantages of IT for both investors and regulators, it should not be overlooked that the reliance on technology carries potential inherent risks such as computer breakdowns, overloading of systems, and hacking. As we move beyond this point we will develop the possible strategies for some financial centres.

Notes 1.

2. 3. 4. 5.

We are not concerned with the question whether financial services should be regulated at all, or why there is special regulation for financial firms. This goes beyond the scope of our study and has been dealt with elsewhere (see e.g. Benston and Kaufman [1996], Dow [1996], and Dowd [1996]). The ‘or’ might well be an ‘and’. Belgium, Canada, France, Germany, Italy, Japan, The Netherlands, Sweden, the UK, and the USA. They also contemplate existing imperfect competition, economies of scale, differentiation and associated non-competitive prices. Price Waterhouse (1988: 22) stress that caution must be exercised in interpreting the [data] concerning cross subsidisation and the problem in price comparability must be noted. It is also important to stress [...] that

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many of the products represent the margin over wholesale money market rates and therefore the “prices” do not represent the cost to the consumer. [...] the data would not be suitable as a measure of consumer prices. Prices are also exclusive of consumer tax. 6.

This has been calculated as weighted average of price comparisons compared with average of the four lowest observations. The weighting system used was designed to attempt to reflect the importance of the different services in value added. [...] Also of significance is the fact that where prices are below the average of the four lowest it is assumed that no increase in prices would result from integration. (Price Waterhouse 1988: 23; footnote 2)

7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19.

20.

21.

22.

23. 24. 25. 26.

Quoted in Owen, R (1992). The role of technology will be discussed in ‘The impact of Technology’. See e.g. Anderton (1995), Dale (1990), or Goodhart et al. (1988). Such as the collapse of The Bank of Credit and Commerce International (BCCI), and Barings, or the misappropriation of the Maxwell pension funds. The concept of arbitrage means that traders take advantage of an anomaly in prices or rates in different markets. E.g. they buy in one and simultaneously sell in the other market. Ex-chairman of the Securities and Investment Board (SIB) in the UK. Quoted in Steil (1992). Directive 77/780/EEC, OJ L 386, 30.12.1977. Directive 88/361/EEC, OJ L 178, 8.7.1988. It also included the abolition of the dual exchange market in Belgium and Luxembourg. Directive 89/299/EEC, OJ L 124, 5.5.1989. Which consists of items like revaluation reserves, securities of indeterminate duration, hidden reserves, commitments of members of cooperative societies and subordinated loans. Directive 89/647/EEC, OJ L 386, 30.12.1989. See ‘European and International Regulation’. Second Council Directive 89/646/EEC on the coordination of the laws, regulations and administrative provisions relating to the taking up and pursuit of the business of credit institutions and amending Directive 77/780/EEC, OJ L 386, 30.12.1977; corrigenda in OJ L 158, 23.6.1990 and OJ L 296, 27.10.1990. The core banking activities within the scope of mutual recognition are in detail: acceptance of deposits and other repayable funds; lending; financial leasing; money-transmission services; issuing and administrating means of payments (credit cards etc.); guarantees and commitments; trading for own account or for account of customers; participation in securities issues; advice to undertakings on capital structure, industrial strategy and related questions, and advice and services relating to mergers and the purchase of undertakings; money broking; portfolio management and advice; safe-keeping and administration of securities; credit reference services; safe custody services. The individual and total ‘qualifying’ holdings of banks in non-financial companies are limited to 15 and 60 percent respectively of a bank’s own fund. Shares held temporarily are not counted in these limitations. They also do not apply to holdings in insurance firms and companies performing services secondary to banking. Universal banking means that banks are not separated into commercial or investment banks (a segmentation we find e.g. in the USA and Japan). The German banking law requires its universal banks to offer a wide range of retail banking, investment and securities transactions in order to obtain a licence (see e.g. Henderson 1993). Second Council Directive 89/646/EEC. Second Council Directive 89/646/EEC. COM (90) 447 final; September 1990. Commission Recommendation 87/63/EEC, OJ L 33, 4.2.1987.

68 27. 28. 29. 30. 31. 32. 33. 34. 35. 36. 37. 38. 39. 40. 41. 42.

43. 44. 45.

46. 47. 48.

49. 50.

51. 52. 53. 54. 55. 56. 57.

The future of European financial centres Directive 94/19/EC, OJ L 135, 31.5.1994. Directive 95/26/EC, OJ L 142, 22.7.1995. Except in some clearly defined circumstances for reasons of consumer protection. Directive 73/239/EEC, OJ L 228, 16.8.1973. Directive 88/357/EEC, OJ L 172, 4.7.1988. Where the policy-holder, or group to which he belongs, meets two out of three conditions; and the figures relate to balance-sheet size, turnover and number of employees the figures are found in accounts prepared in accordance with other directives. Directive 79/267/EEC, OJ L 63, 13.3.1979. Directive 90/619/EEC, OJ L 330, 29.11.1990. Directive 91/675/EEC, OJ L 374, 31.12.1991. The Technical Committee of the IOSCO, which is made up of representatives of securities regulators in the major markets, also works on the harmonisation of capital standards for securities firms. Directive 87/345/EEC, OJ L 185, 4.7.1987. Directive 89/298/EEC, OJ L 124, 5.5.1989. Directive 88/627/EEC, OJ L 348, 17.12.1988. Directive 89/592/EEC, OJ L 334, 18.11.1989. Directive 85/611/EEC, OJ L 375, 31.12.1985. Whereby UCITS (e.g. unit trusts) are defined as ‘undertakings whose sole object is the collective investment in transferable securities of capital raised from the public and the units of which are, at the request of the holders, repurchased or redeemed out of the undertakings’ assets’. In more plain words, UCITS are open-ended mutual funds. Directive 88/220/EEC, OJ L 100, 19.4.1988. Commodity futures and options are excluded. The role of coordinator was mainly pursuit by the BIS. The 1988 Basle Accord replaced different national regulations for capital adequacy by a single, internationally accepted, framework. Its main objective were to strengthen the soundness of the international banking system and to remove regulatory differences affecting the international competitiveness of banks. See also p. 50 of this chapter. As in the SBD. See ‘A blueprint for Europe’s financial markets’. E.g. Proposal for a Council Directive on a Common System of Withholding Tax on Interest Income (OJ C 141, 7.6.1989) and Proposal for a Council Directive amending Directive 77/799/EC Concerning Mutual Assistance by the Competent Authorities of the Member States in the Field of Direct Taxation and Value-Added Tax (OJ C 141, 7.6.1989). See e.g. Organisation for Economic Cooperation and Development (OECD) (1991). In fact, a trader with one of the international investment houses explained that in his firm everyone who develops a new financial derivative has 15 minutes to convince the chairman of the usefulness of this new product. If the chairman does not understand it, the ‘developer’ gets a second 15-minute chance. After this the instrument can either be implemented or is ‘dead’. Discussed earlier in this chapter. Total capital requirements are computed as the sum of a specific risk charge plus a general market risk charge, namely an unexpected interest rate change. See ‘A blueprint for Europe’s financial markets’. Bilateral netting agreements reduce the credit risk by the off-setting of mutual claims and liabilities from pending OTC derivative contracts such as options and forward contracts, and interest rate and foreign exchange related swaps. Including the difficult to supervise off-balance sheet activities such as OTC derivatives. Smart cards store information in a micro-chip in the card. Dimson and Marsh (1989) have shown that these trends have led to a higher degree of market integration, and that markets will move in the same direction.

5 A game theory approach to financial centres

As we have shown above, financial centres compete to become the predominant centre in their hemisphere or even the leading financial centre in the world. We now turn to the question of how they formulate their plans, or strategies, for the future. When outlining their strategies financial centres are faced with uncertainty about their competitors’ strategies and status, as well as the environment in which they will be operating. This chapter is designed to present some basic ideas on game theory1 that will then be applied to London and Frankfurt in their roles as financial centres. One could, of course, have chosen a more formal approach and analyse, say, Cournot-Nash solutions. However, we are convinced that a more complicated framework will not add anything to the analysis nor will it shed light on strategies other than the ones discussed below.

Some theory Decisions are generally made under any one of three conditions, namely certainty, risk, and uncertainty. These three conditions reflect the knowledge a decisionmaker, a player, has about his own and other players’ status, strategies, and preferred outcomes. Under certainty a player has prior knowledge at his disposal. At the time he makes a decision he already knows his own and his opponent’s status, possible strategies and responses, as well as the outcome for each of those strategies. He only has to decide on the preferred outcome, and act accordingly. In the case of a decision under risk a player knows the probabilities of each event occurring respectively of a strategy to be chosen, and the associated outcomes. The probabilities in turn are well known. This condition applies for example to many gambling games. Most decisions are, however, made under uncertainty. Players have no meaningful prior knowledge. Therefore, all assumptions they make about the occurrence of an event are based on subjective probabilities. Decisions under uncertainty include considerations about the beliefs one player has about other players’ preferences and strategies. We now look at types of players and the different games they can play according to their preferences and to the information they hold.

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Strategic forms As we will see below, games can easily become very complicated. They are therefore often analysed in a reduced or strategic form. A player chooses a strategy before the game starts. His strategy can be thought of as a complete plan on how to play the game, specifying each move in any situation. It is only valid for this particular player and game, and for a given information set. Usually the player will not only cover himself for situations which he believes are probable to occur, but he will also develop strategic moves for events that are unlikely to happen. If his game plan is not based on any probabilities this is called a pure strategy, which is based on observations during the game. In both cases, given each player’s strategies, there is a unique outcome of the game and thus a payoff for each player that can be illustrated using a matrix. A complete description how a game can be played, no matter whether each player has one move only or whether the game is sequential, can be given using the extensive or tree form. This is represented in Figures 5.1 to 5.4 and will be explained in a moment. Games can also follow a randomised, or mixed, strategy. Here rational play is non-deterministic, which means that the game can not be played following a single pure strategy. Hence the payoffs for each player are only expected payoffs as shown in Figure 5.5.

Strategic decisions The central premise of game theory is that in the decision-making process the decisions of all players involved determine the final, unique outcome. Each player’s decision depends upon the strategies chosen by the other players for each move. Players will opt for the strategy which is certain or at least most likely to produce the preferred outcome. Adopting general game theory for financial centres we will begin with a game involving two players, an incumbent, say the leading financial centre in the world, and a challenger, which can be any other financial centre. In Figure 5.1 we assume that the challenger moves first. This makes sense as it is the latter who might gain from a change of the existing situation. We consciously say ‘might’ and not ‘will’ for reasons that will become apparent later. However, in Figure 5.1 we have the situation where the challenger can choose any of two strategies: he can decide to challenge the incumbent (‘action’) or not to challenge (‘no action’). If he opts for the latter, the status quo will prevail, which means there is an outcome to the game. As soon as the challenger selects ‘action’ as his strategy the incumbent has to respond to the challenge. This means the game is not finished yet. In the decision tree this is represented by a so-called node, which implies that the second player, the incumbent, now has to act according to his strategy2. This leads us to Figure 5.2. The first part of the tree is simply a reproduction of the previous figure. We are now interested in the incumbent’s response to the challenge. He can either accept or reject it. If he takes up the gauntlet (‘accept’), the game will continue with the challenger having to further develop his strategy. The second option (‘reject’), however, would determine the outcome of the game (‘compromise’)3. In Figure 5.3 we reproduce the previous figures but the game is

A game theory approach to financial centres

Figure 5.1 Challenger’s first decision

Figure 5.2 Incumbent’s reaction

Figure 5.3 Challenger’s second decision

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Figure 5.4 Two types of incumbent

once more extended by adding the challenger’s second decision. After the incumbent has decided to accept the challenge, the challenger must decide between terminating the game (‘stop’) or continuing his challenge. This latter strategy would lead to competition between the two financial centres, whereas the former (‘stop’) means that the status quo will prevail. The status quo is, however, different from the ‘noaction-status-quo’ and thus marked with an asterisk. It should be noted that both ‘competition’ as well as ‘status quo*’ denote outcomes and hence the end of the game. Before we examine the potential payoffs, we shall explore one more extensive form which is shown in Figure 5.4. In this scenario, the challenger has no prior information on whether he faces an aggressive or a conciliatory incumbent. The attitude of the latter is determined by some chance event. As a consequence, the decision tree has two main branches. The upper one represents the game in case of an aggressive incumbent, the lower one depicts the game with a conciliatory incumbent. The outcomes of the latter are marked with two asterisks4 to help us distinguish between the two types of incumbent. Once the type of the incumbent is determined the two branches are essentially a copy of Figure 5.3. The two broken lines which connect the challenger’s nodes stress that he has no knowledge which type of incumbent he faces when he has to choose his next move. It is not necessary to link

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the incumbent’s nodes as he knows the outcome of the initial chance event, that is to say he knows whether he is aggressive or conciliatory. Having thus explained how games can be played, we will now turn to the outcomes of various strategies.

Preferences and outcomes As we have seen, the fundamental elements of any game are a challenge, a response, and a final decision leading to an outcome or payoff. In the following we will explore the latter using the most extensive form of the strategies described above, that is Figure 5.4. Figure 5.4 states the case where the challenger faces uncertainty as to what type of incumbent he has to deal with, an aggressive or a conciliatory player. Once a chance event has determined the type of incumbent the challenger, who has no information on the outcome of that chance event, makes his first move. We recall that the actual game plan is identical for both cases, only the outcomes vary. We start on the upper branch of the decision tree. If the challenger opts for no action nothing will change, hence we call the unique, and certain, outcome ‘status quo’. The second initial strategy that can be pursued is ‘action’. This forces the incumbent to respond to the challenge. We assume first that he accepts it, so that the challenger in turn has to make his next decision. If he chooses to continue the challenge, the outcome will be competition between the two financial centres. The challenging centre will try to overtake or at least to catch up with the incumbent centre either overall or in certain areas. It may only attempt to take away as much trading in e.g. financial futures and options as possible. Alternatively, it may aim at becoming the leading financial centre itself. At the same time the incumbent will want to stabilise or even further advance his lead. However, the challenger has also the option to stop his challenge, even though the incumbent accepted it. As in the ‘no action’ scenario the status quo would prevail. We have marked the ‘action’ status quo with an asterisk as we believe that the two outcomes are not entirely identical. In this latter case the challenger backs down from his initial challenge. This might indicate that he miscalculated the probabilities of the incumbent’s reaction, that is to say he expected the incumbent to choose ‘reject’. We assume that at the end of the game the strategies and outcomes are known to everyone. Therefore, the challenger might now be regarded as being weak. He either lost his nerve for the challenge, or he bluffed right from the beginning of the game. There is also the possibility of some event having occurred during play which changed the position of the challenger in a way that made it unwise to continue his strategy. However, this would not only be written down as bad luck but also indicate some inherent weakness in his challenge as he was not strong enough to accommodate that event. He might e.g. have been in the process of developing a new trading system which he expected to give him a decisive advantage over the incumbent. Due to technical failure or lack of professional acceptance the project had to be abandoned, and the challenger felt no longer in a position for a successful attack on the incumbent’s status.

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Going back to the incumbent node, instead of accepting the challenge the incumbent can choose to reject it. We call the resulting outcome ‘compromise’. Considering that we are dealing with an aggressive incumbent, it seems less likely that he will opt for this strategy. Nonetheless, there are several reasons why he might prefer this outcome. First, the incumbent, representing the leading financial centre, will act from a position of strength. This enables him to follow any of his possible strategies. If he assumes that the challenger is serious about his challenge, he will not expect him to stop it. Although the incumbent has the strength to win any kind of competition he may not be willing to incur the cost of it. Second, the incumbent may feel insulted by any kind of challenge and therefore rejects it as a matter of principle. Third, if he enters into competition with the challenger, others might be encouraged and follow that same strategy. Fourth, the incumbent may know that he is not as strong as his position suggests, he therefore has to fear the outcome of any competition and prefers a compromise. Finally, the incumbent knows whether he is aggressive or conciliatory; the challenger, however, is not in possession of this information. The latter’s ignorance in turn is known to the former. If the incumbent expects the challenger to assume he is ‘aggressive’, he will also expect to gain more from a compromise than the challenger will, and to gain more from following this rather than any of the other strategies at his disposal. The challenger, supposing an aggressive incumbent, might figure that a compromise is by far the best possible outcome. He loses face if he opts for the ‘stop’ strategy and expects to lose more than he might win in a competitive scenario. The incumbent might hence expect the challenger to accept a ‘token’ compromise that is of very little cost to himself. If the incumbent is under the impression that the challenger believes him to be conciliatory whereas he is aggressive, then the latter will underestimate the strength of the former, which the incumbent intends to turn to his advantage. A possible compromise is e.g. the cooperation in developing a new trading system which can be accessed by members of let’s say the stock exchanges in both the incumbent’s and the challenger’s country. We next examine the lower branch of the tree where we have a conciliatory incumbent. Again, the type of the incumbent is not known to the challenger. The immediate strategies and outcomes are identical to the ones we have just discussed. However, the quality of the outcomes varies, and they are therefore marked with two asterisks to distinguish them from the outcomes of the upper branch. If the challenger chooses ‘no action’ we again have a unique, and certain, outcome called ‘status quo**’. As before, the position of neither challenger nor incumbent will change due to this strategy. Should the incumbent reveal his type at the end of the game, say in order to embarrass the challenger, there would be a loss of face for the latter. He might be perceived as lacking confidence and competence. The alternative first decision for the challenger is ‘action’, which requires the incumbent to respond in any of two ways. In the ‘accept-continue’ scenario the two players will compete with each other. The main argument here is the same as the one developed above. However, we have to take account of the fact that this time the

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incumbent is conciliatory, a fact not known to the challenger. For him competition would be the preferred outcome if he assumed the right type of the incumbent. In this case he would calculate that he will gain more through competition than the incumbent, and that he will gain more than he would through any other strategy. If, on the other hand, he believes the incumbent to be aggressive, he would very likely not choose this outcome. Therefore his choice of strategy depends upon the probabilities that he assigns to encountering each type of incumbent. We can think of some exceptions which make it likely that the challenger prefers competition even if he assumes, rightly or wrongly, that the incumbent is aggressive. He might believe that the incumbent’s strength is overestimated, or that his own position is underestimated, or both. In this case he would have no reason to fear a competitive outcome. If these beliefs are non-existent, then he might prefer the status quo (‘status quo***’) to prevail. His initial challenge might have served as a warning that he is progressing towards becoming a serious challenger. He might hope that he impressed other potential players sufficiently to prevent them from challenging the incumbent and from challenging the position of the challenger himself. However, if he believes that the incumbent is conciliatory he is less likely to opt for this strategy. Returning to the incumbent’s strategy, he might choose to reject the challenge because his preferred outcome is a compromise (‘compromise**’). The argument here is the same as in the case of an aggressive incumbent. The strategies and expected outcomes are summarised in Figure 5.5. Each player has four possible strategies at his disposal. The challenger can choose ‘action’ or ‘no action’ and ‘stop’ or ‘continue’ whereas the incumbent can opt for ‘accept’ or ‘reject’ for each of his types – ‘aggressive’ or ‘conciliatory’. Consequently, we need a four-by-four matrix in order to show the outcome for each pair of strategies. For the sake of simplicity we assume that the probabilities of each move occurring are ½. There is a ½ chance that the incumbent is aggressive, and a ½ chance that he is conciliatory. The utilities the players receive from each outcome are denoted as uCH(outcome) for the challenger and as uI(outcome) for the incumbent. To clarify this process, let’s look at field [5]. The challenger opts for ‘action’ and ‘continue’, the incumbent chooses ‘accept’ if he is aggressive, but ‘reject’ if he is conciliatory. If the incumbent is aggressive, he accepts the challenge. The challenger decides to continue, leading to the outcome of competition between the two. If the incumbent is conciliatory, he rejects the challenge, and the outcome is a compromise. All these moves and outcomes have a probability of ½. From [5] we can then read off the expected utilities for both players given this particular pair of strategies. The notation used in the matrix is CI for competition, CII for compromise, and SQ for status quo. As can be seen from Figure 5.5, we distinguish the outcomes for the ‘no-actioncontinue’ and ‘no-action-stop’ scenarios though they are the same. This stresses that if the challenger refuses to move, meaning if he chooses ‘no action’, the game is over regardless of the incumbent’s strategy. These strategies are equivalent since they lead to the same probability distribution over all outcomes for any of the

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Figure 5.5 Expected utilities

incumbent’s strategies. Hence, we could minimise the right-hand side of the matrix to one single strategy. For the sake of completeness, however, we have given the extensive form in Figure 5.5.

An application: London and Frankfurt We have shown in a very general game-theoretic framework how the interaction of two decision-makers can lead to various outcomes. In this section we attempt to apply this setting to London and Frankfurt. With regard to our decision trees we can simply replace ‘incumbent’ with London and ‘challenger’ with Frankfurt. The overall game plans remain the same. We will first examine the positions of the two players in relation to each other. This forms the basis for analysing the motivations for their strategies and the preferred and likely outcomes.

The players As we have seen in the previous chapters, London is an international financial centre whereas Frankfurt is a European one. We will now construct a profile for

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each centre in order to evaluate their strengths and weaknesses overall as well as in relation to each other. The main areas of investigation will be the size and share of markets, trading systems, credibility and reputation. In 1995 turnover in equities on the London Stock Exchange (LSE) was DM3,329bn5 which represents an increase of 5.9 percent from the previous year. By comparison, turnover on the stock exchange in Frankfurt decreased by 12.7 percent from DM1,495bn in 1994 to DM1,306bn in 1995. This shows that the volume of equities traded in Frankfurt reaches only 39 percent of that in London. If we distinguish between the value of domestic and foreign equities traded in the two centres, the picture looks slightly favourable for Frankfurt where domestic shares are concerned. In this area it leads London by 15.4 percent. However, the setting presents a very glum view with regard to foreign equities. Here Frankfurt only reaches 2.4 percent of the volume traded in London. This is also reflected in the proportion of turnover value in foreign equities to domestic equities for each centre. In Frankfurt trade in foreign shares accounts for 2.5 percent of trade in domestic shares, whereas in London it amounts to 122.3 percent. Put differently, turnover value of foreign shares in Frankfurt equals 2.4 percent of total turnover value in shares, and 55 percent in London. The value of all foreign equities transacted via the London Stock Exchange added up to £790,784m in 1995 which is a 9.1 percent increase from 1994. Behind Japan and France the largest proportion, 10 percent, is in German equities. We have not obtained corresponding figures for Frankfurt Stock Exchange (Frankfurter Wertipapier Börse, or FWB) but considering the very small number for turnover in foreign equities the country specific analysis is negligible in this case. Pagano and Roell (1990a) point out that this trend of London taking business away from continental financial centres started after the ‘Big Bang’. Moreover, once a stock is being traded on the London Stock Exchange, ever more trade is diverted from the home country to London (Pagano and Roell 1990a: 74). The total value of companies listed at the London Stock Exchange is almost three times as high as that in Frankfurt. This is not due to differences in the size of companies listed but to their larger number. At the end of 1995 there were 2,839 companies listed on the London Stock Exchange of which 18.9 percent were foreign firms. The corresponding figures for the Frankfurt Stock Exchange were 657 and 33.5 percent respectively. Although the former has in total over four times more companies listed, Frankfurt has a relatively higher proportion of foreign firms. Comparing the number of contracts traded on the Frankfurt and London derivatives exchanges, DTB and the London International Financial Futures Exchange (LIFFE) respectively, we find that while DTB kept its volume almost constant, the number of contracts traded on LIFFE declined by 13.3 percent from 1994 to 1995. This, however, should not disguise the fact that the total number of derivatives contracts traded on LIFFE is more than double that traded on DTB6. After having shown the volume of trade we now turn to the issue of how financial products are traded in the two locations. In addition to the floor trading system, trading on Frankfurt Stock Exchange is conducted through IBIS, the integrated

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Figure 5.6 Volume on stock exchanges in DM bn (1994/1995)

Figure 5.7 Volume on derivatives exchanges: Contracts traded in 1,000s (1994/1995)

A game theory approach to financial centres

Figure 5.8 Domestic and foreign turnover value in £ bn (1995)

Figure 5.9 Listed domestic and foreign companies (end 1995)

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stock exchange trading and information system, which was introduced in 1991. IBIS allows participants, who remain anonymous during the bid and ask process, to transmit orders from anywhere provided they have a trading screen. It aims at keeping transaction costs low through a direct settlement system. Intermediaries need not take a position themselves but can execute trades on behalf of clients immediately. The exchange views IBIS as a system that guarantees a high degree of transparency as regards prices, trading volume, turnover, bid and ask quotes, and ensures market depth and liquidity (Deutsche Börse 1993). During the first three quarters of 1996 share turnover in IBIS was 39.17 percent of all share trading on Frankfurt Stock Exchange (Deutsche Börse 1996)7. Not only the stock exchange but DTB, too, operates a fully computerised trading system. This makes Deutsche Börse, the ‘parent company’ of both exchanges, the only provider of fully electronic trading systems for the cash and derivatives markets from a single source. In order to attract foreign investors, Deutsche Börse has launched access points for DTB and IBIS trading screens in London and Paris. DTB trading screens have also been authorised by the US Securities and Exchange Commission. In Asia, Hong Kong and Kuala Lumpur have both adopted the DTB trading system (Deutsche Börse 1996). The London Stock Exchange has for some time tried to replace its outdated Transfer Accounting Lodgement for Investors Stock Exchange Management for Principles (TALISMAN) system which was introduced in 19798. After the very costly Transfer and Automated Registration of Uncertified Stock (TAURUS) disaster9 it has now developed CREST (CRESTCo’s share dealing settlement at the LSE). For some time the two systems will operate in parallel to ensure a smooth transition from one to the other. TALISMAN was closed in April 1997. CREST provides electronic book entry transfer of registered stock. The bid and ask prices are channelled through Stock Exchange Automated Quotation (SEAQ) and SEAQ International respectively. This continuously updated database contains the market makers’ bids and offers, and displays reports of completed trades. The more sophisticated and efficient the settlement system, the quicker are the times it takes to settle trades and the lower are the costs involved. IBIS in particular aims at keeping the movement of paper to the bare minimum by entering trades immediately on the screen. Settlement can be completed instantly but should not take longer than two days (Deutsche Börse 1996). The working of CREST cannot be evaluated yet as the system is still in a transitory phase. Under the three-year Sequence programme the London Stock Exchange has adopted the T+5 settlement regime which means trades are settled within five days. At present the exchange manages to fulfil this obligation for 75 out of 100 trades. Table 5.1 summarises the key activities of the two stock exchanges, whereas Table 5.2 presents the advantages and disadvantages of both London and Frankfurt. The latter table is based on the questionnaire results as analysed in Chapter 3, on the relevant literature, and on direct observation. The advantages of one financial centre are usually the disadvantages of the other location. Nonetheless, we list some disadvantages for each marketplace which are specifically mentioned in the

Trading services Number of bargains2

Settlement services

London Frankfurt:

Transparency 3

Regulatory activities

++ +

306 247

Number of members

Supporting Members

Costs of running stock exchange London: £177m Frankfurt: £137m

Financial Management

Table 5.1 Key activities of the London and Frankfurt Stock Exchanges (1995)1 Capital raising

London: Frankfurt:

Unusual price Research 4 movements London: 10,000 London: Frankfurt: N/A Frankfurt:

London: Frankfurt:

Daily average of bargains London: 52,843 Frankfurt: 1,415

75% 77%

Turnover in domestic shares London: £323bn Frankfurt: £382bn

Settlement time

Investigations of insider trading London: 1,150 Frankfurt: 26+

13.0m 0.5m

Companies on Exchange London: 2,839 Frankfurt: 657 Turnover in foreign shares London: £395bn Frankfurt: 9bn

London: up to 10 days Frankfurt: max 2 days

London: Frankfurt:

Employees

Market value of companies London: £907bn Frankfurt: £373bn Turnover in trading system London: N/A Frankfurt: 37.7%

1,017 1,172

Capital raised from issues5 London: £12.8bn Frankfurt: £2.5bn

Sources: LSE (1996a), Deutsche Börse (1996), Bundesministerium der Finanzen (BMF) (1995), The Economist (various), own calculations. TALISMAN in London; IBIS in Frankfurt. Proportion of trades published immediately. ++ indicates that London conducts more in-depth research. Excluding eurobonds.

New companies London: 351 Frankfurt: 12 1. 2. 3. 4. 5.

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Table 5.2 Advantages and disadvantages of London and Frankfurt London Disadvantages Advantages Human resources Supporting services Tradition Size of markets Diversity of markets Diversity of financial products Banking sector International banks Innovation Liquidity

Frankfurt Disadvantages Advantages

Technocratic Market access

Strength of DM Growing market Strength of bond market

Domination by big banks Complacency

TAURUS disaster

Unified trading system

Financial scandals International outof-town airport

Cultural life

Inefficient public transport system

Dull

International city airport Short distances

Language Smaller city: less congestion, cheaper housing, lower office rents 1 1. Prime office rents per month in 1996: Frankfurt $40/m2; London $60/m2 (The Economist 10 August 1996).

questionnaire responses. We can deduce from the analysis that the main reasons for the different standing of the two financial centres are to be found in the organisation and the working of the various markets. However, factors like the attractiveness of and quality of life in a location should not be underestimated.

The strategies The remainder of this chapter will examine some of the possible strategies European centres can choose to enhance their respective positions as well as the potential payoffs. These strategies are based on the assumption that London is the leading financial centre in Europe and indeed the only international financial centre in this hemisphere. We will first conduct this exercise for London and Frankfurt before extending it to Paris in particular and other European centres in general. The

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possibilities for potential actions by all participants are virtually unlimited. We have chosen to focus on a number of key areas which we believe are significant to the future of financial centres. Considering only London and Frankfurt, the latter can choose between three main strategies. First, Frankfurt can aim at replacing London as the main financial centre in Europe. Second, it can choose to further develop its strengths and take business away from London in those areas. Third, Frankfurt can resign itself to second place and focus on sustaining its lead over its continental rivals. For all three options it can either be honest about its intentions or bluff, that is pretending to follow one strategy while actually pursuing another. In addition, Frankfurt has another choice which falls somewhat in between the previous three strategies. It could opt to establish a network with other centres. The reasons for networking, however, fall into one or more of the stated categories. The networking option will thus not be analysed separately. London, on the other hand, has the options of either competing or rejecting the challenge. If London perceives its position in relation to Frankfurt as secure, it will very likely decide not to be distracted by a weak challenger and instead concentrate on the global competition with New York and Tokyo. There is, however, the possibility of London accepting the challenge even though it does not feel threatened by it. This way of action may be preferred in order to crush any future challenge to its predominance in Europe and to underline its present strength. In addition, we have to consider the situation in which London accepts or rejects the challenge because it acknowledges at least a partial threat to its position. If the latter were to occur the city has the additional option of networking or forming alliances in the same way as Frankfurt. Again, for the reasons stated above, we will not consider this separate from the other strategies. We first turn to the case of Frankfurt signalling that it aims to replace London as the leading financial centre. Considering the findings from our analysis so far, it is very unlikely that Frankfurt would seriously choose this strategy. The location is lagging behind London in almost all areas that are regarded as important for a financial centre to succeed. Frankfurt would need to attract business in stocks, bonds and derivatives alike. It would need to attack London’s historically strong position in foreign exchange trading as well as its international banking sector. In addition, improvements in human resources and supporting services are of paramount significance. Above all, Frankfurt would have to overcome the appeal of London’s tradition in financial services. Thus, an honest attempt by Frankfurt to replace London’s overall leadership is not at all likely at this stage. There is, however, the possibility that Frankfurt only pretends its will to surpass London. This belief is, of course, not susceptible to proof but the prospect is suggestive. Let us look at the different combinations of signals and responses in this context as summarised in Figure 5.10. Assume Frankfurt chooses to signal its intention to replace London but in fact bluffs. If the latter rejects this challenge, Frankfurt might argue that this move strengthens its own position as it indicates that London does not feel as secure in its position as it might. London, on the other hand, could very well point

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out that it is so secure in its leadership that it does not need to pay any attention to the movements of a weaker financial centre. This in turn would reinforce London’s dominance. The probabilities of London rising to the challenge are accordingly low. If, against expectations, the location feels vulnerable, it will very likely not compete as it could loose some of its reputation but has very little to gain. On the other hand, if London perceives itself as being invincible, it might well opt to take up the challenge in order to call Frankfurt’s bluff. This latter scenario would obviously embarrass Frankfurt and weaken its position not only in comparison to London but also in comparison to its continental rivals. All points considered, it is thus rather unlikely that Frankfurt could gain anything from following this strategy. The other extreme is the case where Frankfurt accepts that London is the leading financial centre and the only true international location in Europe. If Frankfurt honestly signals this view, London has no reason to take any action at all as there is no challenge to which it could rise. Suppose, however, that London believes Frankfurt is bluffing, and that in fact it seeks an opportunity to surpass the former. Assuming that London regards itself as a strong location it will either respond to the challenge in order to reinforce the relative positions of the two financial centres, and to strengthen its reputation at the international level in its competition with New York and Tokyo, or it will refuse to deal with Frankfurt as there is nothing to gain for London in competing with a weaker location. If the contrary is true, and London feels threatened in its leadership it could compete with Frankfurt in the hope to reinstate its dominance, or it could reject the challenge as action bears the risk of losing more than there is to gain. Recalling the analysis of the strengths and weaknesses of both locations it seems most likely that in this scenario London will have no incentive to yield to Frankfurt’s challenge. Let us now explore the most likely of the three main strategies at Frankfurt’s disposal, that is a partial challenge. The relative strengths of Frankfurt are its unified trading system which guarantees shorter settlement times than those in London and the bond market. More important, the location is a growing market which has not reached its full potential yet. Frankfurt has already started to challenge internationally in some areas. It has, for instance, introduced a competitive bonus system in order to attract traders and managers of international calibre10. London’s response to a challenge from Frankfurt depends first on whether it perceives this challenge as a serious threat, second on whether it thinks it can afford to lose certain types of business, and third on whether it sees itself in a strong or in a weak position. Again the probable outcomes are shown in Figure 5.10. Considering the gap between the two locations it seems a safe assumption that London does not feel particularly threatened by other European financial centres. It will therefore either not be particularly concerned to counter any challenge or, to show off its strength, it will be tempted to put the challenger back into place. For the moment we can state that the best strategy for Frankfurt is to resign itself to second place behind London and compete with its continental rivals, or to partially challenge London in those areas where it has a relative advantage. For London the

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Frankfurt signals Replace London

London responds

1 = Not at all likely 5 = Very likely London competes Weakness Strength London rejects Weakness Strength

Partially challenge London

Resigned to second place

Bluff

Honest

Bluff

Honest

Bluff

Honest

1 3

1 1

2 2

4 2

3 3

1 1

5 5

5 5

2 3

2 4

3 5

1 1

Figure 5.10 Signals and responses

implications are not particularly relevant either way as the gap between the two financial centres is too obviously in the latter’s favour to give cause for concern.

Preferences and outcomes We can now transfer the strategies developed in the preceding section to the decision trees discussed earlier. The first strategy is for Frankfurt, the challenger, not to take any action against London, the incumbent. The status quo will prevail and neither centre is better or worse off, therefore the payoff is (0,0). A more elaborate strategy for Frankfurt is to chose ‘action’. London can then rise to the challenge or reject it. Suppose first that London rejects the challenge. In this situation the payoff for either player can be positive or negative but not the same for both. If the markets believe that London opted for ‘reject’ from a position of strength the payoff would be in the form of (1,1)11 meaning London gains through restating its dominance, while Frankfurt, not being regarded as a serious threat, loses. There is of course the possibility that Frankfurt loses not quite as much as London gains. Provided the former gets credit for having challenged at all, this may well be perceived as an improvement in Frankfurt’s position as a financial centre, thus the payoff could be (1,-0.5) or even positive for Frankfurt like (1,0.5). If, on the other hand, the view prevails that the reason for London’s rejection is that Frankfurt poses a threat to its leadership, the payoff could be negative for London and positive for Frankfurt as in (-1,1). ‘Reject’ would then be interpreted as London feeling weak and being anxious that in competition with Frankfurt it has nothing to win but something to lose. However, for reasons discussed in the previous section, this last scenario is very unlikely. Let us next assume that London accepts the challenge. This could be either a sign that Frankfurt’s challenge is not taken seriously, and that London expects the challenger’s next move to be ‘stop’. It could, however, indicate that London believes it has to rise to the challenge since to ‘reject’ would be interpreted as a weakness. Furthermore, London might react from a position of strength in order to squash future challenges from Frankfurt or any other financial centre. Finally, London could

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take a wider view and send a signal to the international markets. In other words, in order to safeguard its reputation as an international financial marketplace (as opposed to a European one) it has to show that it can keep its European rivals at bay. Either way, the moment London accepts the challenge the ball is back in Frankfurt’s court. The latter is then again faced with two possible strategies: ‘stop’ or ‘continue’. Suppose first Frankfurt decides to stop its challenge. In this case the status quo remains although it will differ from the ‘no action’ outcome. It will be interpreted as a signal that the challenge was not serious from the outset or that Frankfurt mistakenly believed London would choose ‘reject’. Thus, although the immediate outcome causes no change to the status quo, in the long run Frankfurt loses some credibility. It is not clear whether London would gain from this situation but it will certainly be no worse off. Therefore, we could obtain possible London-Frankfurt payoffs in the form (0,-1), (1,-1) or (0,-2). An alternative explanation for Frankfurt’s ‘stop’ strategy could be that initially it was serious about the challenge but then some chance event occurred which forced the challenger to alter its strategy. We can use the trading system as an example. Assume Frankfurt has a well tried and respected system whereas London is facing problems in its attempt to install a new system. This in fact happened in March 1993 when the London Stock Exchange had to cancel its new settlement system, TAURUS. Suppose further that Frankfurt immediately identifies this as an area where it can gain at the expense of London. Thus it opts for the challenge. If London can repair the damage faster then expected, Frankfurt would be forced to abandon its challenge. Equally, if investors’ confidence in London is great they will wait for a new system to be installed. Let us next turn to the ‘continue’ strategy. This would lead to competition between London and Frankfurt with an uncertain outcome. One possible result is that one of the two centres wins and the other one loses which would yield payoffs such as (1,-1) or (-1,1). However, the outcome need not be so clear cut. Both locations could lose. While they are competing with each other, another international centre may move ahead of London and another European centre overtake Frankfurt. This may well leave the relative positions of London and Frankfurt unchanged, thus generating a payoff (0,0). Nonetheless, both centres would have lost to a third party and therefore have overall payoffs in the form (-1,-1) or (-1,-2). In essence we can identify two motives for Frankfurt to challenge London. First, it can aim at surpassing London overall and become an international financial centre itself. Second, it starts a partial challenge in order to narrow the gap to London, and to consolidate its position as the leading European centre. Taking into account the findings from earlier chapters as well as the profile of the two players as summarised in Tables 5.1 and 5.2, Frankfurt’s preferred outcomes are threefold. First, it will want to strengthen its strengths such as the bond market, the trading system, its infrastructure, the turnover in domestic shares, and its derivatives trading. Second, it will hope to improve on its weaknesses such as the turnover in foreign shares, the

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number of listed companies, market access, and the domination by the big banks. Third, it may benefit from London’s weaknesses such as the trading system and settlement times, its infrastructure, and the turnover in domestic shares. Our questionnaire results as reported in Chapter 3 suggest that London is so far ahead of Frankfurt that an overall assault by the latter is very unlikely to be fruitful. Thus, Frankfurt should choose a strategy of partial improvement and possibly narrowing the gap to London. If Frankfurt opts for this strategy it is implied that it expects London to be a conciliatory incumbent (see Figure 5.4). Had it reasons to assume that London will respond aggressively, and given its own strategy, it would decide against a challenge since the likely loss is greater than the (un)likely gain. Furthermore, the findings from Chapter 3 support the view that Frankfurt should aim at combining the three aforementioned outcomes: strengthen its strengths, improve its weaknesses, and cash in on London’s weaknesses. Incidentally, London’s weaknesses are perceived by market participants as being Frankfurt’s strengths. London, on the other hand, has no reason to regard Frankfurt as a threat. It knows about its superior position among the European financial centres. Thus, Frankfurt’s probable assumption that London is a conciliatory incumbent appears to be very likely. London will prefer to concentrate its energy on the international competition from say New York and Tokyo. The main strategies and responses are summarised in Figure 5.10.

An extension: Frankfurt and Paris versus London In this chapter we have so far only considered two financial centres, London and Frankfurt, and their potential strategies. The most recent survey on financial centres, our own 1996 study, points towards Paris as Frankfurt’s main rival. We will now present a brief extension of the above game theory analysis by looking at the likely scenarios when the players are London, Frankfurt, and Paris.

Some strategies Once we extend the London-Frankfurt game there are several scenarios which could occur. We will consider five of them. First, Frankfurt and Paris cooperate to overtake London as the leading financial centre in Europe. Second, Frankfurt and Paris cooperate in order to establish themselves as international financial centres. Third, Frankfurt and Paris accept that London is in a league of its own, and aim at staying ahead of other European centres such as Amsterdam or Luxembourg. Fourth, Frankfurt and Paris accept London’s superior position as an international financial centre and compete to become the leading European centre. Finally, all European financial centres cooperate in order to compete worldwide.

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Strategies and actions Let us first assume that Frankfurt and Paris cooperate in order to challenge London’s position as the leading financial centre in Europe. The main strategies at their disposal are full cooperation, partial cooperation, joint ventures, and competition. The reason for including the latter will become clear in a moment. Considering the findings of the surveys discussed in Chapter 3, one would expect the two financial centres to concentrate on trading systems, the exchange of information, innovation, regulation, credibility, reputation, and market share. Suppose Frankfurt and Paris decide to focus on trading systems. They can either develop one such system together (joint venture), adopt a system that is already implemented and well tried in one of the two marketplaces (cooperation), or continue using their own systems but guarantee mutual access to their respective trading systems (cooperation). They may even agree that companies quoted on one exchange are automatically admitted to the other. While cooperating in either of the above ways, each centre may well further develop its own system. The latter case becomes highly likely if we assume that the two financial centres have the same policy target: to claim the leading position among European financial centres. This is in fact already happening. The German and French derivatives exchanges, DTB and MATIF, set up an integrated, fully electronic trading system called TRADEUS12. TRADEUS, whose first phase started in September 1994, was initially based on DTB’s established system. However, both exchanges together further developed this existing system. The cooperation was formed as a response to the increasing globalisation of financial services and has a strict international orientation. Looking at Figure 5.7 we can see that it was sensible for the two locations to link their derivatives trading. In 1994/95 DTB and MATIF together performed as well as LIFFE, the London derivatives exchange. Considering that DTB is a relatively new exchange, which only opened trading in 1990, there appears to be scope for further progress. DTB increased its average daily volume from just below 30,000 contracts in 1990 to over 270,000 by mid-1994 (Deutsche Börse and MATIF 1994: 18). Whereas part of this success can be explained by the worldwide increase in the use of financial derivatives, part of it may also be due to DTB being one of the few derivatives exchanges worldwide that was fully electronic from the very beginning of its operation. Despite their cooperation in the area of derivatives, Frankfurt and Paris are in overall competition for the European leadership. This excursion covers strategies one, two and four outlined in the previous section. The two centres (partially) cooperate in order to overtake London as the leading financial marketplace in Europe while at the same time aiming at being ahead of the other and eventually becoming a global player. We have not found any evidence that Frankfurt and Paris are worried about competition from other European locations, thus we can discard strategy three13. This leaves us with strategy five: all European financial centres cooperate in order to be ahead of their international competitors. The single market programme stipulated the establishment of a single European financial market. Of all possible

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scenarios strategy five comes closest to this idea. It essentially requires the partial cooperation that is already in place between Frankfurt and Paris to be transposed to the EU level. However, having established that the cooperation between Frankfurt and Paris is anything but altruistic, it is difficult to imagine a true single financial market in Europe.

An outlook We know that London is the only international financial centre in Europe, and that Frankfurt is ‘the leader of the (European) pack’. London leads by a wide margin which makes it unlikely for any European centre to pose a threat to London’s overall dominance. The most promising strategy for Frankfurt is therefore to challenge London in those areas where it itself is strong and the latter is weak, and to reinforce its leading position among European centres. In order to ensure the success of the first part of this strategy, Frankfurt may opt for cooperation with other centres. This cooperation need not be restricted to Paris. However, given that Paris is the closest overall challenger to Frankfurt, the latter might believe that working together with Paris, partially or overall, provides an opportunity to control the main rival and to stabilise its own leadership.

Notes 1. A comprehensive survey of game theory can be found e.g. in Eatwell, Milgate and Newman (1989); Morrow (1994) or Romp (1997). 2. What those strategies might be will be analysed in the second part of this chapter. 3. Outcomes, or payoffs, will be dealt with in more detail under ‘Preferences and outcomes’. 4. Recall that we used one asterisk to distinguish the two different status-quo outcomes in Figure 5.3. 5. Sources for figures in this section: Deutsche Börse (1996), London Stock Exchange (1996a), own calculations. See also Figures 5.6 to 5.9. 6. See Figure 5.7. 7. Only Deutscher Aktienindex (DAX) issues. 8. For an explanation of the working of TALISMAN see e.g. Chapman (1991) and London Stock Exchange (1996b). 9. See e.g. The Economist 20 March 1993, The Economist 3 July 1993. 10. This was particularly pointed out by several responses to the questionnaire survey. 11. The first figure denotes London’s gain or loss, while the second indicates the gain or loss Frankfurt experiences. 12. For details see Deutsche Börse and MATIF (1994). 13. That is under the assumption of honesty. It may well be that both or one of the two centres is worried about, say, Luxembourg but is even more anxious that admitting so would be perceived as a weakness.

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Appendix 5.1: Further evidence Table 5.3 Stock exchange listings and turnover (1997) Number of newly listed companies Number of stock corporations Turnover Domestic Foreign Total Domestic Foreign Total (Number of shares) FWB 1 BdP LSE NASDAQ NYSE

35 47 243 561 216

730 2 39 76 63

765 49 282 637 279

700 683 2,465 5,032 2,691

1,996 179 526 455 356

2,696 862 2,991 5,487 3,047

3,569,304 727,726 7,027,966 7,816,194 10,354,026

1. Figures are for all German exchanges. However, FWB accounts for 80 percent of total turnover. The figures are therefore a very good approximation.

Table 5.4 Turnover at derivatives exchanges (number of traded contracts) 1996 DTB MATIF MONEP LIFFE SOFFEX CBOT

77,314,480 68,293,238 8,571,453 167,940,452 39,522,530 222,438,505

1997 112,164,106 68,366,035 18,641,637 204,847,164 32,094,697 242,698,918

Table 5.5 Foreign shares quoted at FWB

Main

Eastern European

USA Japan Netherlands UK Luxembourg Canada Switzerland Italy France Croatia Czech Republic Estonia Hungary Kazakhstan Poland Russia Slovakia Slovenia

1996

1997

177 70 31 28 3 31 24 34 17 1 13 1 7 0 0 7 1 0

352 93 58 53 53 49 46 45 40 1 20 5 17 1 3 22 2 2

6 Conclusions: Some implications for London and Frankfurt

In this study we have chosen to focus on a number of key topic areas which we believe are significant to understand the relative positions of financial centres. Each chapter seeks to provide the reader with an overview of the main issues, and with a framework within which to gain a perspective on those issues. A theme which runs throughout the whole paper is the supremacy of London among European financial centres.

A summary In Chapter 2 we establish the factors which historically determined the rise of one financial marketplace above others. In essence, financial centres historically emerged after wars, in the wake of technological developments, on the back of a strong currency, and in response to relative regulatory standards. They were typically located along trade routes. Initial economies of scale led to self-sustaining growth and the centralisation of activities. The key elements of industrial location theory can be applied to financial centres yielding the result that the aforementioned economies of scale are the most important parameter for the success of a location as a financial centre. However, supply-side factors such as human resources and premises, demand-side issues such as access to customers, sunk costs, as well as psychological influences cannot be neglected. In addition we analyse a set of other determinants such as tradition, geography, culture, government policies, and the relevance of central-bank location. They all enter the equation although their importance varies as we show in Chapter 3. Our subsequent inquiry into several European locations indicates that there are essentially two ways to become an international financial centre. First, a marketplace can expand on the back of economic growth and international trade. Second, a location has to create a political, fiscal, regulatory and institutional environment in which international financial business can thrive almost regardless of the features of the host country. The supremacy of London in the 19th century was based on the former, while its ascension after World War II was largely due to the latter.

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Having demonstrated how financial centres, and international financial centres in particular, emerged historically, we then investigate the views of individuals and institutions active in the markets (Chapter 3). The findings presented in Chapter 3 are based on our own 1996 questionnaire survey of the views professionals and academics have on financial centres. Bankers, traders, consultants, governments, central bankers and others involved in the financial markets, either in practice or theory, in several countries were asked to complete a questionnaire with special regard to London and Frankfurt. The results from this survey are then compared to the findings of a panel study by Abraham et al. (1993), a survey by the Institut für Kapitalmarktforschung (1990) in Frankfurt, and a study by the Centre d’Observation et de Prospection Sociale (1986) in Paris. Thus we cover a period pre and post European single market legislation. A summarised version of the responses to all four surveys reveals that for a location to become an international financial centre five factors are of utmost importance: the availability of skilled personnel and supporting services, a full range of developed markets, the presence of international institutions, the state of market regulation, and a well developed infrastructure. As some factors such as political stability and the free movement of capital have become identical for locations over time, the specific characteristics of a financial centre such as human resources or the diversity and size of markets, have become decisive in determining the attraction of a location as an international financial centre. Comparing the relative positions of the main European centres we find that in all four studies London is in a league of its own and is, in fact, regarded as the only international financial centre in Europe. Frankfurt is considered to be its main rival ahead of Paris and other locations. Whenever there is a crisis in financial services, much of the ensuing debate focuses on the regulation of financial market activities. Thus, in Chapter 4 we analyse European and international approaches to regulation, the objectives pursued, and the types of regulation that the supervisory authorities have at their disposal. Taking account of our emphasis on European financial centres we pay special attention to EU attempts to create a single market for financial services in Europe before discussing some issues such as the use of financial derivatives and the role of technology. We show that at the international level several attempts to unify the regulatory framework have failed so far, and that at present three different sets of regulation prevail which are represented by the BIS, the IOSCO, and the EU. The latter has been highly active in regulating financial markets with regard to banking, insurance, and securities. It has chosen an approach based on three principles: harmonisation of key prudential standards, home country control, and mutual recognition. On this basis financial institutions authorised in one member state are automatically admitted to trade in the whole Union. They are essentially equipped with a single licence or, as it is commonly referred to, a single European passport. The three most ground-breaking directives for a single financial market in Europe are the SBD, the ISD, and the CAD. The first two introduce the single passport while the CAD links capital to market risk. Despite this tight legal framework we find that several adjustment problems mainly with regard to the harmonisation

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of standards have yet to be resolved. We then take a regulator’s point of view and discuss the problems that arise when regulating a highly leveraged market where a large number of trades are not conducted through organised exchanges. Furthermore, we show that advances in technology are a two-sided sword. On the one hand, they encourage globalisation through the fast flow of information and the interlinking of markets, thus increasing efficiency. On the other hand, the reliance on technology carries risks such as computer breakdowns, overloading of systems, and hacking. After examining the historical emergence of financial centres, analysing current and past perceptions of the strengths and weaknesses of some locations, and establishing the rules by which financial market activities are governed, we finally present the strategies at the disposal of financial centres in Europe (Chapter 5). Here we draw on the findings from previous chapters and in particular those from Chapter 3. We outline the strategies for both London and Frankfurt, and extend this approach by allowing for cooperation between the latter and Paris. The chosen strategies depend on the preferred outcomes for each financial centre. In the case of Frankfurt, the potential aims are to replace London as the main financial centre in Europe, to develop its own strengths and take business away from London in those areas, or to focus on sustaining its lead over continental rivals such as Paris. London’s response to any of Frankfurt’s challenges depends on how it perceives its own position. If it regards Frankfurt as a serious rival, it will choose a strategy that keeps the former at bay. If, on the other hand, London considers itself as being in a league of its own, it may well choose to ignore the challenge and instead focus on its international competitors, namely New York and Tokyo. A cooperation between Frankfurt and Paris can take many forms. We discuss five of them. First, Frankfurt and Paris can cooperate in order to overtake London. Second, the two locations cooperate in an attempt to establish themselves as international financial centres. Third, Frankfurt and Paris can work together and aim at staying ahead of other European centres such as Amsterdam or Luxembourg. Fourth, accepting London’s superiority the two centres compete to become the leading European financial centres. Finally, all European financial centres can agree to cooperate in order to compete worldwide. We investigate all the above scenarios and conclude that the most likely strategy for Frankfurt on its own is to challenge London in those areas where Frankfurt itself is strong, and to improve its weaknesses while at the same time consolidating its position as the leading European financial centre. This summarised overview of the research provides the chapter-by-chapter conclusions. We will next present the main overall conclusions.

A European and an international financial centre We have shown that countries tend to set up one main financial centre. The same is true at the international level. Historically there has been one main financial centre in Europe, one in America, and one in Asia. The analysis of four studies covering the period 1986 to 1996 has yielded the result that this observation still holds. All surveys indicate that London is perceived as being in a league of its own among

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financial centres in Europe, and that indeed it is regarded as the only financial centre of international standing in this hemisphere. Other locations are left behind to squabble over becoming the top European centre. The two main contenders here are Frankfurt and Paris. In the 1996 survey Frankfurt attracts more and a wider variety of comments than Paris. This may be due to any of a number of reasons. It could indicate that those active in finance are more knowledgeable about the German location, or that they have stronger opinions, positive as well as negative, about Frankfurt. Due to the dominant political and economic position of Germany, its main financial centre may be taken more seriously than others. In fact some respondents to the 1996 survey mentioned that their chief reason for establishing at least an office in Frankfurt was that their clients expected them to have a presence in the largest European economy. Last but not least, despite the criticism levelled at the location, Frankfurt appears to be the more important and attractive centre. This is confirmed by the fact that not only in the 1996 survey but also in the three previous studies under consideration Frankfurt is regarded as the ‘leader of the pack’. Frankfurt dominates Paris although the latter is credited with more and stronger positive attributes. This result begs the question why the relative positions of these two locations are not reversed. The most obvious explanation appears to be that the positive characteristics of Paris, such as an innovative climate, are not perceived as being of overall importance for a financial centre to succeed. Moreover, several respondents to the 1996 survey manifested their irritation with the unwillingness of the French to speak English. Whereas language is ranked as a rather unimportant factor overall, it does seem to have an impact on day-to-day business decisions. We can thus conclude that Frankfurt attracts more negative criticism than Paris but performs better in key areas and is therefore regarded as being superior to the French location. Bearing in mind the findings from Chapter 3, Frankfurt and Paris are battling to become the main European financial centre with the former currently having the edge over the latter. However, as the German proverb ‘wenn zwei sich streiten freut sich der dritte’1 indicates it is by no means a foregone conclusion that either Frankfurt or Paris will emerge as the main financial centre in Europe. Some of the smaller locations, notably Luxembourg, Amsterdam and Zürich, have fared well in all four surveys. If Frankfurt and Paris in their efforts to outperform each other become too inward looking, one of the smaller centres may yet benefit on a larger scale from its specific advantages. The more likely scenario, however, is that Europe hosts one international financial centre, London, one European centre, on current evidence Frankfurt, and several regional or specialist financial centres. Investors can easily spread their activities over many centres depending on the specific strengths and advantages on offer. Dublin for example was complimented on its expertise in collective investment schemes in the 1996 survey but was never regarded as a major player in overall financial activities. In addition, some centres, such as Frankfurt, have historically a very large domestic base whereas others, such as Luxembourg, are characterised through a strong international orientation. Thus, a

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German investor may well raise capital for domestic investments in Frankfurt but conduct his international business elsewhere. Alternatively, some of the smaller financial centres may decide that they cannot compete with the larger locations for wholesale business and instead concentrate on retail activities. Small investors have different needs from large ones: they trade less often and place smaller orders. They also need access to financial expertise which larger, institutional investors frequently develop in-house. It is therefore conceivable that we will not only see a distinction between international, European and regional financial centres but also between wholesale and retail locations.

Geography still matters Ever since the mid-1980s there have been substantial changes in financial markets. Developments in IT have proven to have a significant impact on the working of financial institutions. The place where a decision is made is not necessarily the place of execution any longer. The use of sophisticated computer networks and telecommunication enables market participants to conduct business wherever it suits them. They are no longer confined to geographical centres. One of the major consequences of this increased globalisation of financial services was the extension of new markets, in particular those for financial derivatives. Here the amount in trade became often greater than the turnover in the underlying cash market (Deutsche Börse 1995). In Chapter 4 we have outlined the regulatory challenges brought about by this development. We have also shown that in the process competition between markets and between financial centres has become more intense. Globalisation refers to the creation of a world-wide market such as the trading of the major currencies in any of the world’s financial centres. We have identified three main developments which have increased the degree of globalisation over the past decade or so: deregulation, the growing number of financial conglomerates, and the role of IT. Financial theory tells us that global markets will track each other. This means that through arbitrage traders will exploit price differences in two or more markets. Anderton (1995: 10) points out that ‘the process of globalisation, and the associated development of international banking and finance groups, has been restricted to the wholesale financial markets’. However, the introduction of the single market programme aims to ensure, in theory at least, a global financial retail market in Europe. In the wake of globalisation we would expect the removal of sectoral barriers. In the EU this point has been addressed mainly through the adoption of the universal banking model which ensures that the demarcation line between banking, insurance, and securities has become blurred. At the same time market access should improve. In Chapter 3 we have shown that especially the German market is generally perceived as being difficult to penetrate due to its domination by the big banks. In a global marketplace we might also consider a stronger coordination or even harmonisation of regulatory standards. The analysis in Chapter 4 stresses that the EU is very active in this field but that there is very little cooperation at the international level.

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The Big Bang in 1986 led to significant changes in the financial centre of London, and in particular to changes in the working and the organisation of the stock exchange. Ever since, most exchanges have embarked on a modernisation programme mainly by adopting fully computerised on-screen trading, speeding up settlement times, and in some cases 24-hour trading. Thus, even though globalisation means more than merely advances in technology it is this latter that creates a global marketplace. Technological developments foster an almost instant transmission of news throughout world markets and subsequently an increased speed of market response to news. The use of IT reduces operation costs, and the establishment of electronic trading systems allows scope for around-the-clock trading. The combination of screen and phone or fax enables market participants to conduct business anywhere anytime. Taking all these factors together, geography should not matter any longer. The results of the 1996 survey, however, strongly indicate otherwise. This is neither surprising nor is it unique to financial markets. Geographical concentration can be observed in many sectors of the economy. The international movie industry evolves in Los Angeles, the computing industry in Silicon Valley. Most countries have an industrial belt where the manufacturing industry is located. Even the wholly unregulated Euromarkets have chosen London as the pre-eminent centre although they have no formal geographical basis. Financial markets depend on fast and reliable information flow. IT for all its advantages cannot communicate rumours and personal comments. Especially in retail finance clients require face-to-face contact. Financial centres, as we have seen in Chapters 2 and 3, accumulate talent, knowledge and expertise. These factors, which can broadly be categorised as human resources, are perceived as being of superior importance to market participants. Finally, centralisation and concentration in centres allows the realisation of economies of scale. In addition there might be a whole range of psychological factors which condition human beings’ partiality to a physical centre or basis. The exploration of this possibility is, however, beyond the scope of both this study and its author. The important insight thus is that, despite the globalisation of financial services, geography still matters.

Note 1.

Which loosely translates into: when two are squabbling the third one wins.

7 Epilogue: Recent developments

Most of the research presented so far has been conducted in 1996 and early 1997. Since then there have been several developments with regard to both London and Frankfurt as well as some other financial centres. This is, of course, not surprising as financial markets are synonymous with change, innovation and risk. The main arguments remain unaltered. Nonetheless, this epilogue fulfils a role beyond a mere update. It reveals whether financial centres behave according to the theory outlined earlier and whether the strategies put forward in Chapter 5 live up to reality. Three areas are of particular relevance: stock exchanges, derivatives exchanges, and the impact of the imminent introduction of the euro.

Stock exchanges After several rather embarrassing hiccups when trying to implement a new orderdriven electronic system the London Stock Exchange finally installed its Stock Exchange Electronic Trading System, SETS, at the end of 1997. SETS has been hailed as the biggest change to the UK stock market since the Big Bang eleven years earlier. It is expected that trading costs will be reduced due to narrower spreads, and that transparency will be increased. The exchange anticipated a boost in trading volumes similar to that observed in Paris and Zürich after they introduced electronic trading. Volumes there increased by 20 and 15 percent respectively. One of the major changes is disclosure of identity which will occur at the moment the trade is executed rather than the guarantee of total anonymity. Anonymity throughout is, however, offered by Tradepoint Investment Exchange which sees itself as the electronic rival to the London Stock Exchange. Tradepoint expected to gain from the new situation. Having two competing exchanges in London might be a bad idea in terms of global competitiveness but, so far, Tradepoint has failed to make a significant impact. Regarding SETS the first hitch appeared to be the so-called ‘snake in the grass’ trades. It was discovered that by entering preposterously high or low prices the order remained undetected in the system until someone entered, by mistake, a matching order. The deal would then be executed. In response the exchange assured investors that any such trade would be considered a regulatory abuse of the system and be treated as such. Nonetheless, this served as an untimely

98

The future of European financial centres

reminder of previous disasters, in particular the failed TAURUS trading system. Additional criticism was levelled at SETS once traders had some months experience using it. Spreads have not narrowed by quite as much as initially anticipated. This applies in particular to beginning and end-of-day trading. On the positive side, the exchange managed to cut costs for its members by 60 percent. This notwithstanding at the end of April 1998 the rather damning results of two surveys of leading firms in the City of London were published. SETS was badly criticised in the reports. According to the surveys liquidity has actually decreased under SETS which was also regarded as being too slow. Only a small number of traders could confirm that prices had gone down. One of the surveys was conducted by Tradepoint and might be dismissed as being biased since the exchange would expect to gain from any dissatisfaction with the London Stock Exchange. The second report, however, is the 1998 Reuters Survey of UK Larger Companies which offers no basis for dismissal on the grounds of vested interests. During the same time, Deutsche Börse pursued a twofold strategy. On the one hand it has focused on creating a capital market as technologically sophisticated and efficient as possible. On the other hand partnerships with other exchanges and the attraction of more foreign participants have been high on the agenda. Most notable were the introduction of the new electronic trading system, Exchange Electronic Trading (XETRA), in November 1997, the start-up of Neuer Markt which is the Frankfurt equivalent to the Alternative Investment Market (AIM), some new euro share indices, and links with exchanges in Paris and Zürich. All these measures were intended to prepare Deutsche Börse for EMU. The relentless activity is understandable. Frankfurt might host the fourth largest stock exchange in the world but its market capitalisation in relation to the size of the Germen economy is much lower than that of its counterparts in London, New York and Tokyo. Deutsche Börse sees fewer new issues than the three big exchanges, and the absence of pension funds of the type that is common in the UK means a lack of heavy investors in this investment vehicle. Obviously the latter factor cannot be solved by the stock exchange but would require a reform of the pension law in Germany. In the meantime, great hopes are pinned on XETRA which came at a cost of DM150m. XETRA reduces costs1, and adds both transparency and liquidity by automatically matching buyers and sellers. The system also offers foreign investors remote access via computer links. Having more foreign investors tracking movements at Deutsche Börse might then encourage German companies to be listed in Frankfurt rather than abroad. Furthermore XETRA should increase market integrity as it is easier to spot insider trading and other irregularities. The introduction of the euro will result in competition moving away from national on to sectoral investment decisions. Thus, in addition to open access, Deutsche Börse is forging ahead with global links. The ease of access to XETRA is deemed as especially attractive to smaller exchanges that lack the resources for the development of their own trading systems. Another growth area identified by Frankfurt is the emerging markets in eastern Europe where Deutsche Börse has already assisted St Petersburg to install a new settlement system. A further dimension has been added to Frankfurt’s global

Epilogue: Recent developments

99

ambitions by venturing into the world of indices. Together with the exchanges in Paris and Zürich and Dow Jones it has established the Stoxx index. Stoxx is in fact a group of indices traded on XETRA. It is made up of two blue chip indices comprising 50 top European shares in the euro area and two larger indices that also cover nonEuropean shares2. The announced alliance between the stock exchanges in London and Frankfurt (July 1998) can therefore be regarded as a step towards a pan-European stock exchange. Although London still overshadows Frankfurt as a global financial centre, the approach of the euro has directed investors’ attentions to continental Europe. Furthermore with XETRA Deutsche Börse brings advanced technology to the alliance. Overall, both centres are expected to gain from the link. London has a vital tie-up with what financial journalists like to call ‘euroland’ while Frankfurt will strengthen its appeal. It is thus no surprise that the Paris stock exchange has been pushing vehemently for a widening of this bilateral alliance. If this consolidation between European equity exchanges continues it could result in the creation of a new regional market. While the big companies will very likely turn to the big exchanges, smaller and newer firms will have to rely on regional stock markets.

Derivatives At the beginning of 1998 LIFFE reduced its prices in order to attract business back from DTB. Transaction fees for futures and options were cut by 40 percent and eight percent respectively. A strategic review by LIFFE showed that it had lost business to exchanges using electronic trading systems rather than its own openoutcry system. Some of the larger companies had already scaled down their use of LIFFE. Electronic trading is regarded as the more efficient of the different forms of trading as it allows substantial cost cuts. Cost reduction in turn is not only considered a significant feature for gaining or maintaining the competitive edge in general but especially with regard to the introduction of the single currency. The disappearance of several European currencies and their replacement by the euro will shrink the derivatives market. DTB, which is all-electronic, is not only the newest but also the fastest growing of the European derivatives markets. Its trading volumes in the first quarter of 1998 were almost 53 percent up on the previous year while the corresponding figure for LIFFE is 16 percent3. A particular blow has been DTB’s success in capturing a large chunk of London’s trading in Bunds, the German government bonds. While LIFFE had 70 percent of the Bund contracts in 1997 its share dropped below 40 percent in 1998. This boost encouraged DTB to employ more aggressive advertising. Most famously, or perhaps infamously, the exchange took out one-page adverts in several national newspapers in the UK offering to install its electronic trading system at LIFFE without any charge. Not surprisingly, the Londoners were not amused. Furthermore, at around the same time the Chicago Board of Trade (CBOT), the world’s largest derivatives exchange, and The European Exchange Organisation (Eurex) linked up. The latter is the electronic European exchange of which London

100 The future of European financial centres is not a member. These events unleashed a bout of activity at LIFFE in early 1998. Among the proposals were the introduction of an electronic trading system, relocation of the exchange, and a change in ownership structure by incorporating and floating it on the stock exchange4. In addition it was announced in March 1998 that Datastream and Reuters5 will sell a software package developed by LIFFE that enables the user to access the new electronic system for trading individual equity options (LIFFE connect). The initial plan to develop its own electronic trading system was attacked by members as too costly and too time-consuming6. There appear to be four reasons why LIFFE has lost its competitive edge. First, the management is regarded by many as too inflexible and out-of-touch with everyday business at a derivatives exchange. Second, the institution has been too reluctant for too long to embrace electronic trading. Third, and linked to the previous point, people with vested interests exerted too much influence on maintaining the open-outcry system. This last point refers to the so called ‘locals’ who speculate with their own money. By mid-1988 they accounted for 30 percent of LIFFE’s trading volume. The local traders believe that open outcry gives them an advantage over traders from elsewhere. However, some members of this group have meanwhile changed colours and started to trade with DTB. One argument in defence of open outcry is that it enables traders to chose very complex strategies. While there are only very few trading strategies for Bunds, other instruments such as euromark contracts are more complex. The fact that in March 1998 LIFFE traded one hundred times more three-month euromark contracts than DTB appears to back this view. Given continually advancing IT systems, there is no reason why it should not be possible to develop software sophisticated enough to deal with highly complex trading strategies. Despite widespread complaints about loss of competitiveness and innovation, it was LIFFE who first came up with plans to launch a contract denominated in the euro. This new derivative instrument is a futures contract based on three-month euro-denominated interest rates. It is tipped to become the most heavily traded instrument after the introduction of the single currency. One of its main advantages is that it has the same features as the existing euromark and eurolira contracts. This is no coincidence. Once the German and Italian currencies have been abolished the two can merge into one market priced in euros. Given LIFFE’s huge lead in euromark trades it is assumed that, at least initially, the exchange will have the edge over its competitors with regard to euro contracts. The euphoria over this latest innovation had hardly subsided when, from LIFFE’s point of view, the next blow was exerted. In early July 1998 the London Stock Exchange and Deutsche Börse established a single trading platform in preparation for full EMU. LIFFE’s concerns about this quasi-merger relate to the organisation of the financial industry in Germany, in particular Deutsche Börse’s ownership of both the clearing house and, especially, DTB. The high degree of coordination between these three institutions is regarded as a major threat to London’s role as the predominant European financial centre. It may also help DTB to take over from LIFFE as Europe’s largest derivatives market. While Frankfurt, and Paris for that matter, have developed a single trading system

Epilogue: Recent developments 101 for their cash and derivatives markets, the London markets are segmented and the LSE has already announced that it sees no basis for an alliance with LIFFE as there is too little overlap between their operations. Two points should be made here. First, adopting the same clearing and trading system for cash and derivatives will lead to economies of scale. Second, while the argument for lacking common ground holds at the moment, this might not necessarily be true in future. LIFFE trades mostly in bonds but once European national bond contracts vanish, as they will under a single currency, trade can be expected to shift to equity derivatives. This creates the missing overlap.

The impact of EMU As mentioned before many of the strategic activities by the various exchanges are undertaken with EMU in mind. It is certain that the UK will, at least for the time being, not join the single European currency. Much less certain is the question of whether this will enable Frankfurt to overtake London as the main financial centre in Europe. It is generally anticipated that the introduction of the euro will lead to increased business in equities and bonds as well as mergers and acquisitions. The USA and EU 15 each account for about 20 percent of world GDP and 15 percent of world exports. Yet almost 50 percent of world trade is financed in US dollars compared to only 30 percent in EU currencies. A similar picture emerges with regard to global asset holdings where half the stock of debt issued by developing countries and almost 40 percent of total international debt securities are denominated in dollars. The figures for EU currencies are 16 and 34 percent respectively. More than twice as much global foreign exchange reserves are held in dollars as compared to EU currencies. The former is also ahead in foreign exchange transactions although the gap here is narrower than in the other areas considered. Notwithstanding the fact that EU currencies are at present underrepresented in global transactions many expect that the euro will play a stronger role vis-à-vis the US dollar than individual EU currencies taken together7. Why should this be the case? The euro will have a larger economic base than individual EU currencies. Transaction costs will be abolished. The single currency might thus be more attractive as a unit of account for international trade especially for transactions with developing countries and economies in transition. This applies in particular to countries that aim at future EU membership. Financial transactions will decrease as many currencies are replaced with one single currency. In addition, interest rates are expected to converge further8. This in conjunction with the continuing advance of a single European market for financial services should also lead to an increasing supply of euro-denominated assets as Europe becomes a more attractive financial marketplace. Assuming all this is true the euro should close the gap to the dollar as a reserve currency. This will mainly be due to three reasons. First, the single currency will be held for intervention purposes. Second, given the size of the economic area it will be extensively used. Third, provided the beforementioned argument that more and more assets will be euro-denominated holds, the European financial market will

102 The future of European financial centres have both greater depth and breadth. This can then serve as an incentive for governments and central banks to diversify their reserve holdings in a way that reflects the currency composition of trade flows and financial transactions. These developments point towards increasing demand for the euro. However, any shift away from US dollars into euros will take place gradually. The new currency will first have to prove itself. Investors may need some time to become familiar with it. Furthermore, existing currencies, and this applies especially to the US dollar, like all incumbents have an initial advantage over the newcomer. It is too early to say whether increased demand for the euro will largely stem from the areas discussed so far or whether private portfolio investment will follow the same pattern. The attractiveness of holding different currencies lies in the differentials between economic performances of various countries and their impact on rates of return. In that sense the strength of the new currency and thus its appeal to investors will be determined by the EU’s fiscal and monetary policy mix and the economic growth of the member states. There is no obvious reason why both London and Frankfurt should not benefit from these developments. However, being on the outside might mean that London will capture less additional business. While the total level of investment will increase, investment firms might want to reap the economies of scale generated by a borderless capital market. Until now they needed traders, analysts and mergers and acquisitions specialists in each individual market. Once the markets merge into one European market this will no longer be necessary, and they can concentrate their specialists in one financial centre. Given London’s position not only as the major European but also as the only truly international financial centre in Europe the city might seem the obvious choice. On the other hand, one could argue that firms will move to the location where they already have a critical mass. Either way, centres in the ‘lower division’ such as Paris and Milan will lose out. Frankfurt can nonetheless emerge as the biggest gainer after the completion of EMU. This is mainly due to four factors. First, the German market, as mentioned before, is undercapitalised. While in the near future London will stay ahead of its rival in nominal terms, Frankfurt will continue to grow faster because it starts from a lower level. Second, Frankfurt is already developing a ‘hinterland’. Not only is the German economy almost twice as large as the UK’s but Frankfurt has close links with exchanges in neighbouring countries including the emerging markets in eastern Europe. Third, although our empirical analysis shows that the location of the ECB is not among the top criteria influencing the choice of financial centre it might well give Frankfurt a psychological advantage. Fourth, if DTB wins its battle with LIFFE and dominates the European derivatives market this may well work as a magnet pulling in more business in other areas9. Furthermore, there is some concern in London that the ‘rules of the game’ might turn out to be to its disadvantage. One can only speculate what would happen if Europe’s single capital market were to adopt Euribor rather than Libor as the benchmark for its money markets. And if the European Commission goes ahead with its proposal to impose a withholding tax on bond issues, the entire eurobond market could be driven offshore. Since at present

Epilogue: Recent developments 103 London has by far the largest share of the eurobond business it would be hurt more by any such move than the continental locations. Taking all this together two possible future scenarios emerge. There will either be a pan-European trading system including a common clearing system, or financial activities will be concentrated in one European exchange. London is already isolated and this isolation can be expected to increase further after the introduction of the Euro. Thus, there is a threat that other exchanges will continue to take some of London’s current market share. It appears that London as a financial centre has realised this. Therefore, the announcement in July 1998 of an alliance between LSE and Deutsche Börse can be regarded as a preemptive strike. It represents a complete U-turn for the London exchange which previously rebuffed any suggestion of cooperation with one of its rivals. For Frankfurt, however, it forms part of its overall strategy. The new-found partners have already started to work on a joint access system that allows the top 300 European shares to be traded on either exchange. Rules and regulations are to be harmonised with the aim to eventually establish a single electronic trading system. The EU has made several attempts to accelerate cross-border links among exchanges. In the late 1980s it put forward a proposal that would have seen an EUwide system of integrated stock exchanges which, though integrated, would still trade in individual countries but share settlement and clearing facilities. For the next project, the Price and Information Project for Europe (PIPE), potential participants could not even agree on the objectives. PIPE thus never made it past the first hurdle. Subsequent projects such as Euroquote capsized for similar reasons. The Organisation for Economic Cooperation and Development (OECD) concludes that notwithstanding the co-operation among some exchanges, the trend today is towards competition among exchanges and trading systems. This development will be further spurred by the growth of alternative trading systems and by the implementation of the Investment Services Directive (ISD), in particular the provisions which open up for exchanges giving direct cross-border access to their trading systems. OECD (1996: 22) Considering the developments outlined in this epilogue we have to say that the OECD has got it wrong. This is further supported by Figures 7.1 and 7.2 which show the extent of links between exchanges. Given what looks like a strategic advantage for Frankfurt it appears logical that both London and Paris are worried about being left behind and thus push for formal alliances. While this should benefit the larger players in the short term, it may eventually lead to one or more of them being relegated to the lower leagues. After all, it has been said that ‘the flowers smell sweeter, the closer you are to the grave’10. Oxford, October 1998

104 The future of European financial centres

Figure 7.1 The Eurex network

Figure 7.2 Frankfurt’s network

Epilogue: Recent developments 105

Notes 1. Average transaction costs are expected to go down from DM15 to DM7. 2. The London Stock Exchange already has a family of Eurotop indices. 3. Nonetheless, LIFFE still trades more contracts in total. Its number of 59.72m lots compares favourably to DTB’s 40.238m contracts. 4. LIFFE is currently a non-profit organisation owned by its members. 5. Datastream is a provider of financial data and data analysis. Reuters is an international news service. 6. The estimated cost was £20m–£25m with a development time of 18 months. 7. See for example IMF (1997a). 8. The convergence of long-term interest rates is in fact one of the Maastricht criteria for joining EMU. 9. Although DTB’s trading system allows investors access from anywhere in the world. 10. The Beautiful South: ‘How Long’s a Tear Take to Dry’. (Welcome to the Beautiful South: Go! Records).

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Appendices

A The 1996 Survey A1: Statistics of institutions and individuals European 1

Other

Total

1. Exchanges Stock exchanges Derivatives exchanges

16 7 9

3 1 2

19 8 11

2. Professional institutions2 Banks Investment firms Financial consultancies

64 20 17 27

8 4 4 0

72 24 21 27

3. Central banks

5

0

5

4. Government institutions

1

0

1

31 19 3 9 117

0 0 0 0 11

31 19 3 9 128

5. Academics et al. Academics Financial journalists Researchers and others Total

1. EU as well as other European countries. 2. The figures given in the table refer to the site of the headquarters. All institutions contacted are located in Europe.

A2: Covering letter 115 A2: Covering letter

UNIVERSITY OF BRISTOL Kirsten Bindemann Lecturer in Economics

DEPARTMENT OF ECONOMICS 8 Woodland Road, Bristol BS8 1TN Telephone: (+44-117) 928 8433 Fax: (+44-117) 928 8577

March 1996

Financial Centres Research This research is concerned with a range of aspects regarding the competitiveness of European financial centres. It forms part of a wider research project on the future of international financial centres with special reference to London and Frankfurt. The accompanying questionnaire has been sent to a number of international banks and investment houses, financial consultancies, exchanges, central banks, government departments, and to academics with a background in finance. It is designed to evaluate the criteria for the success of a location as a competitive financial centre, the impact of existing regulation, and the strategies governments choose to strengthen the position of their main financial centre. It would be very much appreciated if you could find the time to complete the questionnaire, and return it in the envelope provided. The results, which will be totally anonymous and strictly confidential, will greatly assist in the progress of this research project.

May I thank you in advance for your cooperation and time.

Yours sincerely,

(Kirsten Bindemann)

116 Appendix A The 1996 Survey

A3: Questionnaire for exchanges

FINANCIAL CENTRES QUESTIONNAIRE This questionnaire evaluates the views exchanges take on financial centres, and on legislation designed to regulate the financial sector. It also reviews the strategies governments pursue to strengthen the competitiveness of their main financial centre. Please be reassured the questionnaire is totally confidential and it will not be possible to identify any individual or individual institution from the analysis.

Would you please indicate 1. From where you respond ......................................................................................... 2. Your occupation ..........................................................................................................

1. In your opinion which are the most important criteria for financial institutions when choosing a location? 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24.

Availability of Capital Human Resources, please specify ............................................................... Language Infrastructure, please specify .......................................................................... Operation cost Economic Growth of Host Country Strength of Currency Banking Sector Bank Secrecy Independence of Central Ban Automatic Continuous System for Transactions Circulation of Information Settlement of Transactions Diversity and Size of Markets Diversity of Financial Product Volume of Transactions Presence of International Banks Innovation, please specify ................................................................................ Financial Tradition, please specify ................................................................. Political Stability Market Regulation, please specify ................................................................. Fiscal Regulation, please specify .................................................................. Commissions, please specify ........................................................................ Other, please specify .........................................................................................

Appendix A The 1996 Survey 117 2. Referring to the list from question 1 what do you believe are the reasons that London is the leading financial centre in Europe? ........................................................................................................................................ ........................................................................................................................................ If other, please specify ...................................................................................................... ................................................................................................................................................

3. Which financial centre poses the greatest challenge to London’s dominant position? In Europe:

(1) Amsterdam (2) Frankfurt (3) London (4) Luxembourg (5) Madrid (6) Milan (7) Paris (8) Zürich (9) Other, please specify .....................................................................

Elsewhere:

(1) Tokyo (2) Hong Kong (3) Singapore (4) Other, please specify .....................................................................

4. If your answer to question 3 is NOT Frankfurt, why not?

................................................................................................................................ ................................................................................................................................ ................................................................................................................................ ................................................................................................................................ ................................................................................................................................ ................................................................................................................................ ................................................................................................................................ ................................................................................................................................

118 Appendix A The 1996 Survey 5. Which exchange(s) do you regard as your main rival(s)? ................................................................................................................................ ................................................................................................................................

Please state the main reasons for your answer ................................................................................................................................ ................................................................................................................................ ................................................................................................................................ ................................................................................................................................ ................................................................................................................................

6. Comparing yourself to your competitors, what do you believe are your main strengths and weaknesses? Strengths

.............................................................................................................. .............................................................................................................. .............................................................................................................

Weaknesses

.............................................................................................................. .............................................................................................................. .............................................................................................................

7. Do you think that the government in your country pursues the right strategies to ensure the competitiveness of the financial sector?

(1) Yes

(2) No

If no, please specify ................................................................................................... ................................................................................................................................ ................................................................................................................................ ................................................................................................................................

Appendix A The 1996 Survey 119 8. Do you expect EC/EU regulation on financial services to be advantageous for European financial centres when competing worldwide?

(1) Yes

(2) No

If yes, will it benefit all centres equally? (1) Yes, please specify ...................................................................................... ............................................................................................................................ ............................................................................................................................ (2) No, please specify ....................................................................................... ............................................................................................................................ ............................................................................................................................ Which financial centre(s) will gain most? ...................................................... ...................................................... ...................................................... Please list the main reasons, why you think the above centre(s) will gain most ................................................................................................................................ ................................................................................................................................ ................................................................................................................................ ................................................................................................................................

Thank you very much for your cooperation and time. Your answers will be treated in the strictest confidence.

Please return the completed questionnaire in the envelope provided. Kirsten Bindemann Department of Economics University of Bristol 8 Woodland Road UK - Bristol BS8 1TN

120 Appendix A The 1996 Survey

A4: Questionnaire for banks, investment firms and financial consultancies

FINANCIAL CENTRES QUESTIONNAIRE This questionnaire evaluates the views financial institutions take on financial centres, and on legislation designed to regulate the financial sector. It also reviews the strategies governments pursue to strengthen the competitiveness of their main financial centre. Please be reassured the questionnaire is totally confidential and it will not be possible to identify any individual or individual institution from the analysis.

Would you please indicate 1. From where you respond .................................................................................... 2. Your occupation ................................................................................................ 3. The location of your headoffice .......................................................................... 1. Which were the most important criteria for your decision to be present at this location? 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24.

Availability of Capital Human Resources, please specify .................................................................... Language Infrastructure, please specify ............................................................................. Operation cost Economic Growth of Host Country Strength of Currency Banking Sector Bank Secrecy Independence of Central Bank Automatic Continuous System for Transactions Circulation of Information Settlement of Transactions Diversity and Size of Markets Diversity of Financial Products Volume of Transactions Presence of International Banks Innovation, please specify .................................................................................. Financial Tradition, please specify ..................................................................... Political Stability Market Regulation, please specify ..................................................................... Fiscal Regulation, please specify ...................................................................... Commissions, please specify ............................................................................ Other, please specify .........................................................................................

Appendix A The 1996 Survey 121 2. Using the list from question 1, what do you think are the most important criteria for a successful financial centre in Europe? ......................................................................................................................... ........................................................................................................................... If other, please specify .................................................................... ..................................................................................................................................

3. Again referring to the list from question 1 what do you believe are the reasons that London is the leading financial centre in Europe? ........................................................................................................................... ........................................................................................................................... If other, please specify ..................................................................... ................................................................................................................................

4. If you had to choose one of the following financial centres for which one would you opt? 1. 2. 3. 4. 5. 6. 7. 8. 9.

Amsterdam Frankfurt London Luxembourg Madrid Milan Paris Zürich Other, please specify ................................................................

Please state the main reasons for your choice ................................................................................................................................ ................................................................................................................................ ................................................................................................................................ ................................................................................................................................ ................................................................................................................................

122 Appendix A The 1996 Survey 5. Which financial centre poses the greatest challenge to London’s dominant position? In Europe:

(1) Amsterdam (2) Frankfurt (3) London (4) Luxembourg (5) Madrid (6) Milan (7) Paris (8) Zürich (9) Other, please specify ................................................

Elsewhere:

(1) Tokyo (2) Hong Kong (3) Singapore (4) Other, please specify ................................................

6. If your answers to questions 4 and 5 are NOT Frankfurt, why not? ................................................................................................................................ ................................................................................................................................ ................................................................................................................................ ................................................................................................................................ ................................................................................................................................ ................................................................................................................................ ................................................................................................................................ 7. Do you expect EC/EU legislation and regulation on financial services to be advantageous for European financial centres when competing worldwide? (1) Yes

(2) No

If yes, will it benefit all centres equally? (1) Yes, please specify ..................................................................... ...................................................................................................................... ...................................................................................................................... (2) No, please specify ...................................................................... ...................................................................................................................... ......................................................................................................................

Appendix A The 1996 Survey 123 Which centre(s) will gain most? ............................................................. ............................................................. .............................................................

Please list the main reasons, why you think the above centre(s) will gain most ................................................................................................................................ ................................................................................................................................ ................................................................................................................................ ................................................................................................................................ 8. Do you think the government of your host country pursues the right strategies to ensure the competitiveness of the financial sector? (1) Yes

(2) No

If no, please specify ........................................................................................... ........................................................................................................................... ........................................................................................................................... ........................................................................................................................... ...........................................................................................................................

Thank you very much for your cooperation and time. Your answers will be treated in the strictest confidence.

Please return the questionnaire in the envelope provided. Kirsten Bindemann Department of Economics University of Bristol 8 Woodland Road UK - Bristol BS8 1TN

124 Appendix A The 1996 Survey

A5: Questionnaire for central banks

FINANCIAL CENTRES QUESTIONNAIRE This questionnaire evaluates the views central banks take on financial centres, and on legislation designed to regulate the financial sector. It also reviews the strategies governments pursue to strengthen the competitiveness of their main financial centre. Please be reassured the questionnaire is totally confidential and it will not be possible to identify any individual or individual institution from the analysis. Would you please indicate 1. From where you respond ........................................................................................... 2. Your occupation ............................................................................................................ 1. In your opinion which are the most important criteria for financial institutions when choosing a location? 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24.

Availability of Capital Human Resources, please specify ............................................................... Language Infrastructure, please specify .......................................................................... Operation cost Economic Growth of Host Country Strength of Currency Banking Sector Bank Secrecy Independence of Central Bank Automatic Continuous System for Transactions Circulation of Information Settlement of Transactions Diversity and Size of Markets Diversity of Financial Products Volume of Transactions Presence of International Banks Innovation, please specify ................................................................................ Financial Tradition, please specify ................................................................. Political Stability Market Regulation, please specify ................................................................. Fiscal Regulation, please specify .................................................................. Commissions, please specify ........................................................................ Other, please specify .........................................................................................

Appendix A The 1996 Survey 125 2. Referring to the list from question 1 what do you believe are the reasons that London is the leading financial centre in Europe? ...................................................................................................................... ...................................................................................................................... If other, please specify ................................................................................................ ...........................................................................................................................

3. Which financial centre poses the greatest challenge to London’s dominant position? In Europe:

(1) Amsterdam (2) Frankfurt (3) London (4) Luxembourg (5) Madrid (6) Milan (7) Paris (8) Zürich (9) Other, please specify ...................................................................

Elsewhere:

(1) Tokyo (2) Hong Kong (3) Singapore (4) Other, please specify ...................................................................

4. If your answer to question 3 is NOT Frankfurt, why not? ........................................................................................................................... ........................................................................................................................... ........................................................................................................................... ........................................................................................................................... ........................................................................................................................... ........................................................................................................................... ........................................................................................................................... ........................................................................................................................... ...........................................................................................................................

126 Appendix A The 1996 Survey 5. Do you think that the government of your country pursues the right strategies to ensure the competitiveness of the financial sector? (1) Yes

(2) No

If no, please specify ................................................................................................ ................................................................................................................................ ................................................................................................................................ ................................................................................................................................ ................................................................................................................................ ................................................................................................................................ ................................................................................................................................

6. Do you expect EC/EU legislation and regulation on financial services to be advantageous for European financial centres when competing worldwide? (1) Yes

(2) No

If yes, will it benefit all centres equally? (1) Yes, please specify .......................................................................................... ...................................................................................................................... ...................................................................................................................... ...................................................................................................................... (2) No, please specify ............................................................................................ ...................................................................................................................... ...................................................................................................................... ......................................................................................................................

Appendix A The 1996 Survey 127 Which centre(s) will gain most? ........................................................ ........................................................ ........................................................

Please list the main reasons, why you think the above centre(s) will gain most ................................................................................................................................ ................................................................................................................................ ................................................................................................................................ ................................................................................................................................ ................................................................................................................................ ................................................................................................................................

Thank you very much for your cooperation and time. Your answers will be treated in the strictest confidence.

Please return the completed questionnaire in the envelope provided. Kirsten Bindemann Department of Economics University of Bristol 8 Woodland Road UK - Bristol BS8 1TN

128 Appendix A The 1996 Survey

A6: Questionnaire for governments

FINANCIAL CENTRES QUESTIONNAIRE This questionnaire evaluates the views governments take on financial centres, and on legislation designed to regulate the financial sector. It also reviews the strategies governments pursue to strengthen the competitiveness of their main financial centre. Please be reassured the questionnaire is totally confidential and it will not be possible to identify any individual or individual institution from the analysis. Would you please indicate 1. From where you respond ........................................................................................... 2. Your occupation ............................................................................................................ 1. In your opinion which are the most important criteria for financial institutions when choosing a location? 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24.

Availability of Capital Human Resources, please specify ............................................................... Language Infrastructure, please specify .......................................................................... Operation cost Economic Growth of Host Country Strength of Currency Banking Sector Bank Secrecy Independence of Central Bank Automatic Continuous System for Transactions Circulation of Information Settlement of Transaction Diversity and Size of Markets Diversity of Financial Products Volume of Transactions Presence of International Banks Innovation, please specify ................................................................................ Financial Tradition, please specify ................................................................. Political Stability Market Regulation, please specify ................................................................. Fiscal Regulation, please specify .................................................................. Commissions, please specify ........................................................................ Other, please specify .........................................................................................

Appendix A The 1996 Survey 129 2. On a scale from 1 to 5 (where 1 = excellent, and 5 = unsatisfactory) how would you rank the main financial centre in your country with regard to the criteria listed below? (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (14) (15) (16) (17) (18) (19) (20) (21) (22) (23)

Availability of Capital Human Resources Language Infrastructure Operation cost Economic Growth of Host Country Strength of Currency Banking Sector Bank Secrecy Independence of Central Bank Automatic Continuous System for Transactions Circulation of Information Settlement of Transactions Diversity and Size of Markets Diversity of Financial Products Volume of Transactions Presence of International Banks Innovation Financial Tradition Political Stability Market Regulation Fiscal Regulation Commissions

1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1

2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2

3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3

4 4 4 4 4 4 4 4 4 4 4 4 4 4 4 4 4 4 4 4 4 4 4

5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5

(24)

Overall

1 2 3 4 5

3. Referring to the list from question 1 what do you believe are the reasons that London is the leading financial centre in Europe? ...................................................................................................................... ...................................................................................................................... ...................................................................................................................... If other, please specify ................................................................................................ ................................................................................................................................ ................................................................................................................................

130 Appendix A The 1996 Survey 4. Which financial centre do you think poses the greatest challenge to London’s dominant position? In Europe:

(1) Amsterdam (2) Frankfurt (3) London (4) Luxembourg (5) Madrid (6) Milan (7) Paris (8) Zürich (9) Other, please specify ...................................................................

Elsewhere:

(1) Tokyo (2) Hong Kong (3) Singapore (4) Other, please specify ...................................................................

5. If your answer to question 4 is NOT Frankfurt, why not? ................................................................................................................................ ................................................................................................................................ ................................................................................................................................ ................................................................................................................................ ................................................................................................................................ 6. Do you expect EC/EU regulation on financial services to be advantageous for European financial centres when competing worldwide? (1) Yes

(2) No

Which financial centre(s) will gain most? ........................................................... ........................................................... .

..........................................................

Please list the main reasons, why you think the above centre(s) will gain most ................................................................................................................................ ................................................................................................................................ ................................................................................................................................

Appendix A The 1996 Survey 131 7. Which strategies does your government pursue to ensure that your country hosts an internationally competitive financial centre? (1) Infrastructure, please specify .............................................................................. ................................................................................................................................ ................................................................................................................................ (2) Fiscal regulation, please specify ....................................................................... ................................................................................................................................ ................................................................................................................................ (3) Market regulation, please specify ...................................................................... ................................................................................................................................ ................................................................................................................................ (4) Innovation, please specify ................................................................................... ................................................................................................................................ ................................................................................................................................ (5) Technology, please specify ................................................................................. ................................................................................................................................ ................................................................................................................................ (6) Banking sector, please specify ........................................................................... ................................................................................................................................ ................................................................................................................................ (7) Other, please specify ............................................................................................ ................................................................................................................................ ................................................................................................................................ Thank you very much for your cooperation and time. Your answers will be treated in the strictest confidence. Please return the completed questionnaire in the envelope provided. Kirsten Bindemann Department of Economics - University of Bristol 8 Woodland Road - UK-Bristol BS8 1TN

132 Appendix A The 1996 Survey

A7: Questionnaire for academics, financial journalists and other researchers

FINANCIAL CENTRES QUESTIONNAIRE This questionnaire evaluates the views academics, financial journalists and other researchers take on financial centres, and on legislation designed to regulate the financial sector. It also reviews the strategies governments pursue to strengthen the competitiveness of their main financial centre. Please be reassured the questionnaire is totally confidential and it will not be possible to identify any individual or individual institution from the analysis.

1. On a scale from 1 to 5 (where 1 = excellent, and 5 = unsatisfactory) how important do you think are the following criteria for financial institutions when choosing a financial centre? (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (14) (15) (16) (17) (18) (19) (20) (21) (22) (23)

Availability of Capital Human Resources Language Infrastructure Operation cost Economic Growth of Host Country Strength of Currency Banking Sector Bank Secrecy Independence of Central Bank Automatic Continuous System for Transactions Circulation of Information Settlement of Transactions Diversity and Size of Markets Diversity of Financial Products Volume of Transactions Presence of International Banks Innovation Financial Tradition Political Stability Market Regulation Fiscal Regulation Commissions

(24) Overall

1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1

2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2

3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3

4 4 4 4 4 4 4 4 4 4 4 4 4 4 4 4 4 4 4 4 4 4 4

5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5

1 2 3 4 5

Appendix A The 1996 Survey 133 2. Referring to the above list what do you believe are the reasons that London is the leading financial centre in Europe? ................................................................................................................................ ................................................................................................................................ ................................................................................................................................ ................................................................................................................................ If other, please specify ....................................................................................... ................................................................................................................................ ................................................................................................................................

3. Which financial centre do you think poses the greatest challenge to London’s dominant position? In Europe:

(1) Amsterdam (2) Frankfurt (3) London (4) Luxembourg (5) Madrid (6) Milan (7) Paris (8) Zürich (9) Other, please specify ...................................................................

Elsewhere:

(1) Tokyo (2) Hong Kong (3) Singapore (4) Other, please specify ...................................................................

4. If your answer to question 3 is NOT Frankfurt, why not? ................................................................................................................................ ................................................................................................................................ ................................................................................................................................ ................................................................................................................................ ................................................................................................................................

134 Appendix A The 1996 Survey 5. Do you expect EC/EU regulation on financial services to have a positive impact on the competitiveness of European financial centres? (1) Yes, please specify .......................................................................................... ...................................................................................................................... ...................................................................................................................... ...................................................................................................................... (2) No, please specify ............................................................................................ ...................................................................................................................... ...................................................................................................................... ...................................................................................................................... Which financial centre(s) will gain most? ........................................................ ........................................................ ........................................................ Please list the main reasons, why you think the above centre(s) will gain most ................................................................................................................................ ................................................................................................................................ ................................................................................................................................ 6. What are the areas that need improvement for financial centres other than London to become internationally competitive financial centres? (1) Infrastructure, please specify ............................................................................... ........................................................................................................................... ........................................................................................................................... (2) Fiscal regulation, please specify ......................................................................... ........................................................................................................................... ...........................................................................................................................

Appendix A The 1996 Survey 135 (3) Market regulation, please specify ...................................................................... ........................................................................................................................... ........................................................................................................................... (4) Innovation, please specify ................................................................................... ........................................................................................................................... ........................................................................................................................... (5) Technology, please specify ................................................................................. ........................................................................................................................... ........................................................................................................................... (6) Banking sector, please specify ........................................................................... ........................................................................................................................... ........................................................................................................................... (7) Other, please specify ............................................................................................ ........................................................................................................................... ...........................................................................................................................

Thank you very much for your cooperation and time. Your answers will be treated in the strictest confidence.

Please return the questionnaire in the envelope provided. Kirsten Bindemann Department of Economics University of Bristol 8 Woodland Road UK - Bristol BS8 1TN

136 Appendix B Other surveys

B Other surveys B1: The Abraham et al. panel study Criteria for the competitiveness of international financial centres Factors of production Availability of capital 1 Size of domestic saving 2 Attraction of foreign capital Quality of human resources 3 Skilled domestic labour 4 Professional expertise Infrastructure 5 Geographical location 6 Transport/telecommunications facilities 7 Operation costs (e.g. rent, services) 8 Time zone 9 Location of important international institutions 10 Location of multinationals

Man-made environment Environment 11 Economic growth of the country 12 Inflation 13 Strength of currency 14 Importance of banking activities 15 Bank secrecy Technology 16 Automatic continuous system for transactions 17 Circulation of information 18 Settlement of transactions Characteristics of financial market Diversity and size of markets 19 Money market 20 Foreign exchange market 21 Capital market Volume of transactions 22 On stock exchange 23 Outside stock exchange 24 Influence of a few superstar shares

Appendix B Other surveys 137 International orientation 25 Presence of foreign banks 26 International assets and liabilities Innovation 27 Availability of sophisticated financial instruments Functioning of market for derivatives 28 Futures 29 Options 30 Attitude towards innovation Financial tradition 31 Stock exchange capitalisation 32 Turnover 33 Importance of bond market Political tradition 34 (Absence of) state intervention 35 Political stability

Regulatory framework Regulation Market regulation 36 Money market: degree of deregulation 37 Capital market: degree of deregulation 38 Takeover bid and money laundering control 39 Organisation of stock exchange 40 Absence of exchange controls Fiscal regulation 41 Withholding tax 42 Stamp tax 43 Stock exchange tax Corporate tax 44 Resident financial institutions

45 Non-resident financial institutions Commissions 46 Transaction costs 47 Type of commissions Source: Abraham, J.P. et al. (1993). pp 16:7, Table 3.1

138 Appendix B Other surveys

B2: The IfK questionnaire Below is a translated list of the ranking criteria, which formed part two of the questionnaire. Respondents were asked to rank each criterion between zero (unimportant) and seven (very important). Referring to the same list, they were then asked to indicate whether the criterion was best fulfilled in London, Frankfurt or Paris.

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 25. 26. 27.

Stability of the political system Stability of the economic system State of deregulation Transaction costs Corporate and income taxes Capital transfer tax Capital gains tax Strength and size of economy Size of domestic savings Convertibility of currency Strength of currency Central bank independence Organisation and structure of stock exchange Liquidity Transparency of markets Information and communications facilities Information and communication costs Attitude towards innovation Diversity of financial instruments Quality and speed of back-office activities Location of foreign financial institutions Location of central bank Availability of skilled personnel Costs of personnel Operation costs Infrastructure Quality of life

Source: IfK (1990): A6

Appendix C The 1996 Survey: Results 139

C The 1996 survey: Results C1: The most important criteria Response to question 1: Academic questionnaire Criterion 1 (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (14) (15) (16) (17) (18) (19) (20) (21) (22) (23)

Availability of capital Human resources Language Infrastructure Operation cost Economic growth of host country Strength of currency Banking sector Bank secrecy Independence of central bank Automatic continuous system for transactions Circulation of information Settlement of transactions Diversity and size of markets Diversity of financial products Volume of transactions Presence of international banks Innovation Financial tradition Political stability Market regulation Fiscal regulation Commissions

26 19 12 12 14 0 0 2 1 0 0 4 15 22 22 15 20 11 6 3 19 5 2

Importance 1 2 3 4 5 4 12 12 15 14 3 6 11 4 3 13 20 12 8 7 11 9 17 7 17 9 15 10

1 0 2 4 3 12 14 13 10 8 12 5 4 1 3 4 2 3 14 9 3 11 12

0 0 4 0 0 16 11 5 14 12 6 2 0 0 0 1 0 0 4 2 0 0 6

0 0 1 0 0 0 0 0 2 8 0 0 0 0 0 0 0 0 0 0 0 0 0

Σ2

Rank 3

37 43 63 54 51 106 98 83 113 118 99 67 51 41 45 50 44 54 78 72 46 68 82

1 3 10 9 8 19 17 16 20 21 18 11 8 2 5 7 4 9 14 13 6 12 15

1. 1 = very important; 5 = not at all important. 2. Σ = 1×a + 2×b + 3×c + 4×d + 5×e (e.g. for criterion (1): 1×26 + 2×4 + 3×1 + 1 + 4×0 + 5×0 = 37). 3. Lower Σ indicates most important criterion, and thus rank 1.

140 Appendix C The 1996 Survey: Results Response to question 1: Professional questionnaire (banks, investment firms, and financial consultancies) Criterion (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (14) (15) (16) (17) (18) (19) (20) (21) (22) (23)

Availability of capital Human resources Language Infrastructure Operation cost Economic growth of host country Strength of currency Banking sector Bank secrecy Independence of central bank Automatic continuous system for transactions Circulation of information Settlement of transactions Diversity and size of markets Diversity of financial products Volume of transactions Presence of international banks Innovation Financial tradition Political stability Market regulation Fiscal regulation Commissions

1. Frequencies 2. Highest Σ indicates most important criterion, and thus rank 1.

Σ1 4 61 7 19 0 0 5 11 3 2 0 23 7 58 49 12 36 6 27 4 23 0 9

Rank 15 1 12 8 18 18 14 10 16 17 18 7 12 2 3 9 5 13 6 15 7 18 11

2

Appendix C The 1996 Survey: Results 141 Response to question 1: Professional questionnaire (exchanges) Criterion

Σ

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (14) (15) (16) (17) (18) (19) (20) (21) (22) (23)

6 11 3 6 12 0 2 6 1 0 3 7 9 14 13 16 11 4 8 7 13 0 6

Availability of capital Human resources Language Infrastructure Operation cost Economic growth of host country Strength of currency Banking sector Bank secrecy Independence of central bank Automatic continuous system for transactions Circulation of information Settlement of transactions Diversity and size of markets Diversity of financial products Volume of transactions Presence of international banks Innovation Financial tradition Political stability Market regulation Fiscal regulation Commissions

1. Frequencies 2. Highest Σ indicates most important criterion, and thus rank 1.

1

Rank 9 5 11 9 4 14 12 9 13 14 11 8 6 2 3 1 5 10 7 8 3 14 9

2

142 Appendix C The 1996 Survey: Results Response to question 1: Professional questionnaire (central banks) Criterion

Σl

Rank 2

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (14) (15) (16) (17) (18) (19) (20) (21) (22) (23)

2 5 1 5 4 2 3 2 2 2 2 0 0 2 3 3 3 2 2 5 2 2 0

4 1 5 1 2 4 3 4 4 4 4 6 6 4 3 3 3 4 4 1 4 4 6

Availability of capital Human resources Language Infrastructure Operation cost Economic growth of host country Strength of currency Banking sector Bank secrecy Independence of central bank Automatic continuous system for transactions Circulation of information Settlement of transactions Diversity and size of markets Diversity of financial products Volume of transactions Presence of international banks Innovation Financial tradition Political stability Market regulation Fiscal regulation Commissions

1. Frequencies 2. Highest Σ indicates most important criterion, and thus rank 1.

C2: Why is London leading?

23 11 6 0 12 0 0 0 0 0 0 0 0 19 12 8 16 8 21 0 12 6 0

Academic

0 69 17 0 8 0 0 31 0 0 0 0 0 53 39 0 44 20 47 0 18 0 0

Banks/investment firms/ financial consultancies

Response to question 2/question 3 for banks, investment firms and financial consultancies1

Availability of capital Human resources Language Infrastructure Operation cost Economic growth of host country Strength of currency Banking sector Bank secrecy Independence of central bank Automatic continuous system for transactions Circulation of information Settlement of transactions Diversity and size of markets Diversity of financial products Volume of transactions Presence of international banks Innovation Financial tradition Political stability Market regulation Fiscal regulation Commissions

Criterion (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (14) (15) (16) (17) (18) (19) (20) (21) (22) (23) 1. Numbers in tables refer to frequency of responses

3 7 2 0 0 0 0 0 0 0 0 0 0 0 0 10 0 0 6 2 7 0 0

Exchanges

1 1 1 1 1 1 1 1 1 1 1 1 1 2 3 2 2 1 2 1 1 1 1

Central banks

144 Appendix C The 1996 Survey: Results

C3: A challenge to London Response to question 3/question 5 for banks, investment firms and financial consultancies Professionals 1 No challenge Frankfurt New York Paris Tokyo Dublin Chicago

Exchanges

58 15 9 3

Academics

Central banks

Overall

5 5 3 3 1

58 58 31 24 14 1 1

6 21

17 17 10 2

8 9

1

1. Banks/investment firms/financial consultancies

C4: Main rivals for exchanges Response to question 5 for exchanges London LIFFE New York NASDAQ Frankfurt Nordic countries OTB Stockholm

11 2 8 1 3 3 1 1

None

3

C5: Government strategies Response to question 7 for exchanges/question 5 for central banks/ question 8 for banks, investment firms and financial consultancies Right strategy Professionals 1 Exchanges Central banks Total

Wrong strategy

24 6 5 35

1. Banks/investment firms/financial consultancies

29 13 0 42

Appendix C The 1996 Survey: Results 145

C6: Comparative strengths and weaknesses of exchanges Response to question 6 for exchanges Strengths Major countries

modern trading system commercial dynamism

Small countries

systems and skills economic and political stability flexibility of people and technology presence of multinationals transparency efficient regulation and monitoring innovation and creativity geographical location customer protection wide domestic product range

We a k n e s s e s Major countries

none

Small countries

lack of economies of scale language legal system market size domination by few large members liquidity

C7: The impact of EU legislation Response to question 8 for exchanges/question 6 for central banks/ question 7 for banks, investment firms and financial consultancies/ question 5 for academics Positive Exchanges Central banks Professionals 1 Academics

15 2 31 26

Negative 3 3 36 7

1. Banks/investment firms/financial consultancies

146 Appendix C The 1996 Survey: Results

C8: Winners and losers: which financial centre will gain most? Response to question 8B for exchanges/question 6B for central banks/question 7B for banks, investment firms and financial consultancies/question 5 for academics

Frankfurt Paris London Luxembourg Zürich Amsterdam Chicago Stockholm Milan Vienna

Academics

Professionals1

Exchanges

24 17

23 8 9 11 5

11 8 6

3 2 2 1 1

Central banks 2

Total 60 33 15 11 5 3 2 2 1 1

1. Banks/investment firms/financial consultancies

C9: Summary of results of the government response As only one government (ministry of finance) completed the questionnaire, we present the results in this summarised form. Answers to Question 1 (1), (13), (14), (18), (24: Liquidity) Answers to Question 2 Criteria ranked 1: None 2: (5) to (10) 3: (3), (14) to (16), (20), (22) to (24) 4: (1), (2), (4), (12), (17) to (19), (21) 5: (11), (13) Answers to Question 3 (19), (3), (14), (21) Answers to Question 4 Frankfurt and Singapore Answers to Question 6 1 Yes: Milan, Paris, Scandinavian capitals Reduction of currency risk and information cost Answers to Question 7 (2), (3), (6) 1 Question 5: not applicable.

Appendix C The 1996 Survey: Results 147

1 An arrow indicates an identical ranking of a criterion by two or more groups.

148 Appendix C The 1996 Survey: Results

C11: Overall ranking Rank 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23

Criteria1 I

II

I

14 2 15 17 21 16 13 1/12

2 14 15 17 16 21 4 5 1 19 20 8/13

6 10 11 14 15 17 28 29

4/19 5 8/23 3/20 18 7 22 11 9 6 10

12 7 3/18/23 22 11 9 6 10

30 33 40 41 52 53 55 57 60 62 63

Σ2

II 11 15 16 19 22 24 31 37 38 39 42 49 50 58 61 64 66 69 71 72

1. I excluding central bank results; II including central bank results. 2. I excluding central bank results; II including central bank results. Σ presents the sum of individual ranks as shown in Table 5.3, e.g. criterion 14 has been ranked second three times (excluding central banks). Thus 2 + 2 + 2 = 6 which is the lowest sum and therefore indicates the most important criterion, meaning rank 1.

Appendix C The 1996 Survey: Results 149

C12: Reasons for London’s leadership Rank 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Criteria (Σall) 2 (88) 19 (76) 14 (75) 17 (62) 15 (54) 21 (38) 8 (32) 18 (29) 1 (27) 3 (26) 5 (21) 16 (20) 22 (7) 20 (3) 4/6/7/9–13/23 (1)

Criteria (Σexcl. CB)1 2 (87) 19 (74) 14 (73) 17 (60) 15 (51) 21 (37) 8 (31) 18 (28) 1 (26) 3 (25) 5 (20) 16 (18) 22 (6) 20 (2)

1. Excluding central bank response.

C13: A comparison of C11 and C12

Index

Abraham survey 26–7, 92; comparisons 41–3; criteria for 136–7; findings 34–7 academics, questionnaire for 132–5; results 139 Amsterdam 11, 17, 35, 94 Anderton, B. 53, 95 Bank for International Settlements (BIS) 50, 64, 65, 92 Bank of England 13, 31 banks/banking: adjustment problems 62; in financial centres 19; overseas, in London 14–15; questionnaire for 120–3; regulation of 55–8; results of questionnaire 140; runs on 53 Basle Accord 50 Basle Committee 50 BCCI, collapse 58 Beckman, M.J. 6, 7 Berrill, K. 53 Big Bang 43, 77, 95 Breedan, Richard 52 Bretton Woods 5 Brittan, Leon 52 Brussels 35, 37 Bundesbank 16 Capital Adequacy Directive (CAD) 50, 61, 64, 92 capital cities: in location theory approach 10 capital controls, abolition of 55–6 capital-asset ratios 62 Cecchini, P. 51 central banks: and financial centres 11; in location theory approach to financial centres 10; questionnaire for 124–7; results of questionnaire 142 central location of financial centres 11–12 certainty, in game theory 69 Chicago Board of Trade (CBOT) 99

Clarke, M. 14, 66 Commission of the European Communities (COM) 9, 12; and regulation 51 Committee on Banking Regulations and Supervisory Practices (Basle Committee) 50 Copenhagen 35 COPS survey 35–37, 92 CREST system (LSE) 80 culture: in location theory approach to financial centres 12 currency: in location theory approach to financial centres 10 Dale, R. 62–3 Datastream 100 Davis, E.P. 6, 8 decisions in game theory 69–73 deregulation 62–3 Dermine, J. 55 desirability bias 47–48 Deutsche Börse 80, 88, 95; electronic trading 98–9; and LIFFE 100 Deutsche Terminbörse (DTB) 38, 80, 88, 90 Devine, P.J. 6 Diamond, D.W. 53 Directive on Own Funds 56 Directive on Solvency Ratios 57 Dixon, R. 51 domino effect 53 Dublin 94 Dudley, J.W. 51 Dybvig, P.H. 53 Eastern Europe 98 economic Darwinism 20–3 economies of scale: external 5, 9; internal 6, 8 electronic trading: by derivatives market 99–101; by stock exchanges 97–9

Index 151 endogenous change and economic Darwinism 20–3 Eng, M. 4–5, 17 euro 101 European Common Market 5 European Community 50, 92, 95; legislation, impact 145 European Exchange Organisation (Eurex) 99; network 104 European financial centres 93–5 European Monetary Union (EMU) 101–4 Exchange Electronic Trading (XETRA) 98–9 financial centres: and central banks 11; changes in 19–20; design of 45–6; emergence of 18, 91–2; game theory on see game theory; historical perspective on 4–6; location theory see location theory approach; regulation see regulation; surveys on see Abraham, COPS, IfK survey, 1996 survey; winners and losers 146 financial consultancies, questionnaire for 120–3; results 140 financial derivatives: electronic trading 99–101; regulation of 63–5 financial journalists, questionnaire for 132–5 Fitchew, G. 51 France: financial centres in 16 Frankfurt: actions in game theory approach 88–9; in COPS survey 36; emergence of 15–16; and EMU 102; in game theory approach 76–82; in IfK survey 38; network 104; and Paris 94–5; strategic decisions 86–7; strategies in game theory approach 82–5, 93; views on 39, 41 Frantfurter Wertpapier Börse (FWB) 77, 80; advantages/disadvantages 82; derivatives exchanged 78; foreign shares quoted 90; key activities 81; listings, foreign and domestic 79; turnover 79, 90; volume of exchanges 78 game theory approach to financial centres 69–90; applications see Frantfurt, London; decisions under 69–73; preferences and outcomes 73–6; strategic decisions 70–3; strategic forms 70 Giovannini, A. 63 globalisation 95 Goldsmith, R.W. 19

governments: policy in location theory approach 12; questionnaire for 128–31; responses 146; strategies 144 Great Britain: financial leadership 5 Grilli, V. 52 Hamilton, F.E.I. 6 harmonization of rules 92; in banking 55; in securities 60 Henderson, R. 51 home-country rule: in banking 55, 57; in securities 60 IfK survey 27–8, 92; comparisons 41–3; criteria for 138; findings 37–40 insider trading, regulation of 60–1 insurance: adjustment problems 62; regulation of 59–60 internal market programme (EU) 50–1 international financial centres 93–5 International Monetary Fund (IMF) 5, 64 International Organisation of Securities Commissions (IOSCO) 50, 92 investment firms, questionnaire for 120–3; results 140 investment services, regulation of 61 Investment Services Directive (ISD) 61, 92 investor protection regulation 54 Italy: financial centres in 16–17 Kelm, M. 20–2 Kennedy, P. 17 Kindleberger, C.P. 5, 10, 11, 12, 14, 15, 16 Krugman, P. 9 Lazar, D. 43 Lees, F.A. 4–5, 17 legal systems 63 liberalisation process of banking 55 life assurance, regulation of 59 location theory approach 6–9; scenarios in 7; sunk costs in 8 London: actions in game theory approach 88–9; challenges to 144; in COPS survey 36; emergence of 13–15; and EMU 102; financial freedom of 19; in game theory approach 76–82; leadership, reasons for 32–3, 41, 143; in 1996 survey 31; overseas banks in 14–15; strategic decisions 86–7; strategies in game theory approach 82–5, 93; supremacy of 18–19; views on 39 London International Financial Futures Exchange (LIFFE) 77, 88; competition to 99–101

152 Index London Stock Exchange (LSE): advantages/ disadvantages 82; derivatives exchanged 78; electronic trading in 97–9; key activities 81; listings, foreign and domestic 79; size of 77; turnover 79, 90; volume of exchanges 78 Luxembourg 35–6, 37, 94 Madrid 35 Marché à Terme International de France (MATIF) 38, 88 Milan 16, 35 mutual recognition: in banking 55; in securities 60 Neal, L. 13, 17 Neven, D. 52, 58 1996 survey 24–6, 92; academics, questionnaire for 132–5; banks, questionnaire for 120–3; central banks, questionnaire for 124–7; comparisons 41–3; covering letter 115; exchanges, questionnaire for 116–9; financial consultancies, questionnaire for 120–3; financial journalists, questionnaire for 132–5; findings 28–34; governments, questionnaire for 128–31; investment firms, questionnaire for 120–3; results 139–49; statistics of 114 oil crises (1973–74, 1979–80) 15 Olsen, R.A. 47 Organisation of Petroleum Exporting Countries (OPEC) 15 Organisation for Economic Cooperation and Development (OECD) 103 OTC derivatives 64–5 Pagano, M. 77 Paris 11, 14, 16, 35–6, 37; and Frankfurt 94–5; in game theory approach 87–9; views on 39, 41 payment systems in banking 58 Pelkmans, J. 9, 12, 20 Plender, J. 13, 14, 15, 19 Post-BCCI Directive 58 Prest, A. 63 Price and Information Project for Europe (PIPE) 103 Price Waterhouse 51, 58 prudential regulation 54 Redwood, John 52 regulation 49–68, 92; of banking 55–8; and deregulation 62–3; European and international 49–52; financial

derivatives 63–5; forms of 53–5; of insurance 59–60; objectives of 52–3; of securities 60–1; and technology 65–6 Reuters 100 Revell, J. 45, 64 Richardson, H.W. 6 risk, in game theory 69 Roell, A. 77 Schumpeter, J.A. 20–2 Second Banking Directive (SBD) 57, 61, 62, 92 Second Non-Life Insurance Directive 59 securities: adjustment problems 62; regulation of 60–1 Single European Act (SEA) 50 Steil, B. 53 Stock Exchange Automated Quotation (SEAQ) 80 Stock Exchange Electronic Trading System (SETS) 97–8 stock exchanges: electronic trading in 97–99; main rivals 144; questionnaire for 116–19; results of questionnaire 141; strengths and weaknesses 145 Stoxx index 99 structural regulation 54 sunk costs: in location theory approach 8 Switzerland: financial centres in 17 systemic risk, regulation of 53 TALISMAN system (LSE) 80 TAURUS system (LSE) 80, 86, 98 taxation 63 technology: and electronic trading 97–9; impact of 65–6, 92–3 Thießen, F. 8 Third Life Assurance Directive 61 Third Non-Life Assurance Directive 61 Townroe 6 Tradepoint Investment Exchange 97 TRADEUS system 88 tradition: in location theory approach to financial centres 10–11 Tsoukalis, L. 55, 57, 62, 63 uncertainty, in game theory 69 Undertakings for Collective Investment in Transferable Securities (UCITS) 61 Vives, X. 52, 58 Wallace, P.C. 13, 14, 15, 19 Zürich 17, 35, 37, 94