«Association for Financial Markets in Europe Annual dinner, London Thursday 3 November 2016 1 All speeches are available online at ...»
Challenges for financial markets
Speech given by
Jon Cunliffe, Deputy Governor Financial Stability, Member of the Monetary Policy
Committee, Member of the Financial Policy Committee and Member of the Prudential
Regulation Authority Board
Association for Financial Markets in Europe Annual dinner, London
Thursday 3 November 2016
All speeches are available online at www.bankofengland.co.uk/publications/Pages/speeches/default.aspx
I am very pleased to have the opportunity to speak tonight at the annual dinner of the Association for Financial Markets in Europe (AFME). The Bank of England has throughout its history had a close association with financial markets and with the institutions that support them.
Indeed, the Bank was instrumental in the creation in 1914 of one of AFME’s distant ancestors – the quaintly named Accepting Houses Committee. The outbreak of the First World War and consequent disruption of international payments threatened to bring down the London markets and the international merchant banks that supported them. The Bank enabled a moratorium on war disrupted payments and offered to purchase the war disrupted bills. One contemporary historian of the City hailed this as “the greatest evidence of London’s strength as a financial centre that could have been 1 desired or dreamt of”.
Over the following century, the Accepting Houses Committee became the forum of the City’s most influential merchant banks; its members enjoyed the implicit backing of the Bank of England. The Committee eventually became part of the London Investment Banking Association which merged with the European part of SIFMA to create AFME in 2009.
Transparency requires me to record, in this genealogy, that one of the founding Houses of the Accepting Houses Committee back in 1914 was Cunliffe Bros, whose founder was actually Governor of the Bank of England at the time. Transparency however also requires me to make clear that he was no relation. I do, however, feel a little sense of eponymous history in speaking here tonight.
Financial markets of course have changed greatly since Cunliffe Bros, with half a million pounds of capital, was a force in the City. I want to look today briefly at how financial markets have grown worldwide, why they are subject to strong pressures to cluster activities in key centres and how this has affected the concentration 2 of financial services in the UK – or as it is often, and misleadingly described, in London.
I also want to touch on two of the fundamental challenges faced by financial markets and the institutions that support them – maintaining, or some would say, restoring their ‘social license’ and managing systemic risk.
And finally, given that this is the Association for Financial Markets in Europe, I will touch briefly on one or two possible implications for European capital markets of the UK’s exit from the European Union.
In passing, I will say a little about how the Bank sees these issues. Our role and responsibilities have evolved as markets have evolved. We are now explicitly charged with the objective of ensuring financial stability in the UK and by extension in the world’s leading financial centre. We no longer stand behind and 1 Hartley Withers. War and Lombard Street (1915), page 99.
2 There are 1.1 million people employed in financial services in the UK – two-thirds of these jobs are located outside of London.
2 All speeches are available online at www.bankofengland.co.uk/publications/Pages/speeches/default.aspx 2 implicitly endorse the credit of the successors of the Accepting Houses. But an essential part of what we do still depends on understanding financial markets and the risks and benefits they create.
The financial market ecosystem
The wave of financial globalisation that happened in the heyday of Cunliffe Bros came to an end with the outbreak of World War I. The world did not turn back to financial globalisation for another 60 years or so.
But the current, second, wave of financial globalisation now outstrips its predecessor. One can see this in the numbers: external financial assets were 60% of global GDP in 1900, 20% in 1960 and are now around 180%.
As part of this, financial markets have grown in size, reach and complexity, and despite the financial crisis have accelerated since the beginning of this century. Global stock market capitalisation is around $70 trillion 3 – around 100% of global GDP – and has tripled in the last 20 years. Global debt securities outstanding are nearly a third higher at just over $90 trillion, having quadrupled over the same period. Turnover in foreign exchange markets has also quadrupled over a similar period to some $5 trillion a day.
Completely new markets have developed to manage and match risk and to expand funding options.
Derivative markets now dwarf the markets in the underlying instruments on which they are based. Total derivatives outstanding have increased nearly six fold over the past 20 years to around $550 trillion. In 1914, such markets existed on a small scale for agricultural products.
Repo and securitisation markets which hardly existed when financial globalisation restarted are now each 4 worth around $12 trillion.
As financial globalisation has grown, so has the tendency for activity to concentrate in financial centres.
Concentration, as Paul Krugman observes, is the most striking feature of many industries’ economic geography. Labour market externalities mean that larger concentrations allow for a more efficient matching between employers and employees, and encourage the formation of a pool of specialised workers.
Concentration increases the scale of the demand for intermediate inputs encouraging the development of more specialisation in the suppliers of those inputs. And concentrations facilitate the exchange of knowledge and skills.
Given the importance of access to specialised labour, to intermediate inputs and to knowledge, it is not surprising that financial services are subject to very strong pressures to concentrate activity in key centres.
All speeches are available online at www.bankofengland.co.uk/publications/Pages/speeches/default.aspx 3 As a knowledge intensive service industry, the financial sector depends crucially on the availability of specialised labour. Complex financial service firms rely on access to a large pool of skilled workers. For example, 390,000 people work in financial services in London and 330,000 in New York, the two largest financial centres.
Financial services have an increasingly complex production chain that depends on the availability of specialised intermediate inputs of both financial and non-financial services. A modern financial market transaction may be the simple purchase or sale of a single financial asset. But it is more likely to be a complex chain of transactions involving a range of financial markets and intermediaries.
One can see this complexity in the value chains of financial services. In 2014, every £100 of Gross Value Added created by the financial services sector in the UK relied on £23 of inputs from other financial services firms and £29 of inputs from legal, accounting, consultancy, information, IT and business support services.
Knowledge and information is a critical input to financial services – perhaps more than any other industry.
Quick access to information can lead to better decisions about the allocation of capital. Information about successful innovations in financial firms’ production processes can lead to more efficient production across the industry.
In addition to these general forces that lead to industrial concentration, there is for financial services the particular importance of market liquidity and the ability to trade efficiently, which depends in turn on a large number of market participants wanting to trade in a particular venue. And the necessary market infrastructure generally has increasing returns to scale.
Concentration in financial markets Financial services concentration has increased with financial globalisation and with the revolution in information technology. There are more financial centres now and the largest have become very large.
This may appear puzzling; the death of distance, the ability to interact instantaneously with market participants and end users anywhere in the world should perhaps have led to less not more physical concentration of financial services. One can only assume for financial services the returns to face-to-face contact, to physical proximity and co-location of workers remain high.
And it is possible that the information technology revolution has perhaps had the opposite effect of making it more possible for activity that used to happen in more localised markets to benefit from the lower costs, greater efficiency and specialised products of the larger financial centres.
As I have noted, international financial activity dried up materially after the First World War. But even accounting for the overall decline, London’s relative importance as a financial centre declined further as the global footprint and importance of the UK economy decreased along with sterling’s reserve currency role. It was only with return to financial globalisation, some 50 years ago, that this process was reversed – leading to the concentration we now see.
One can only postulate, why, over the last 50 years, London has flourished as a truly international – not just a European – financial centre despite the relative decline in global importance of the UK and indeed the European economies as globalisation has advanced. The UK ceased being a surplus country and thus exporting savings in the 1930s (see Chart 1) and moved into a sustained deficit at the start of the 1980s.
There are a number of possible explanations that are not mutually exclusive.
A number of members of the European Union have maintained large surpluses of savings relative to domestic investment. Since the creation of the single market in financial services in the mid-1990s, London has become the financial centre for the whole European region. But while this may explain some of the resurgence of London in the past 50 years, it does not explain it all. London’s revival started well before the EU’s single market in financial services – indeed at a time when most EU members had capital controls.
And the share of non-EU related business is markedly greater than of EU business.
5 This point has been noted by Charles Kindleberger.
6 See ‘The Global Financial Centres Index 20’, September 2016, published by the Z/Yen Group.
5 All speeches are available online at www.bankofengland.co.uk/publications/Pages/speeches/default.aspx 5 A second possible explanation is that modern financial markets are so large that the surplus generated by an original trade or manufacturing activity is far less relevant now than before. After all, since the abolition of capital controls after the end of the Bretton Woods era, financial services have grown a lot faster than global trade.
In the UK, gross financial flows grew rapidly from the 1980s to the end of the 2000s and became larger than trade and current account flows. Once financial flows start to move through a financial centre, the ensuing returns to scale and specialisation generate greater financial flows through the centre. The flows associated with the UK’s extremely large external asset and liability position may have helped to reinforce this dynamic.
A related point, one that I touched on earlier, is that physical location does not matter anymore, since technology allows investors to pick the most efficient location to manage the global allocation of capital. In this case, London is playing the role of asset manager, intermediating flows between different global regions. The investment decision and risk management skills are in London but the assets may be booked elsewhere.
Allied to the increase in gross financial flows, it is possible that financial markets demand different inputs than in the past. For example, the market for derivatives encompasses more human capital (in the form of law experts writing contracts) than physical capital. Given the dominance of UK law, this would tend to encourage activity in London.
Finally, regulatory changes may have played a role. London became the main trading centre for the Eurodollar market in the 1960s. The City went through a wave of deregulation in the 1980s and beginning of the 1990s which may have contributed to its position as a global financial centre.
All of these drivers are likely to have played a part in concentrating financial market activity in London. And indeed they are likely to have been mutually reinforcing.
The social license for financial markets I have described at some length why concentrations of financial services develop and the economies of scale, lower costs and greater efficiency they should bring. In the case of financial markets and financial centres, however, one does have to ask the question, ‘for whose benefit’?
Financial services exist, as we would all agree, to serve the real economy by channeling savings to investment, by providing insurance and by facilitating economic activity and trade.
6 All speeches are available online at www.bankofengland.co.uk/publications/Pages/speeches/default.aspx 6 The great financial crisis and its aftermath was a painful reminder, however, of how financial markets,
particularly in the international financial centres in which they have become concentrated:
Financial markets currently face many challenges but perhaps none is as fundamental as maintaining the support of society for the functions they perform. Meeting this challenge will require them to show that they are fair as well as effective.