Economic Review, Fourth Quarter 2006 - The UK’s Financial Services Sector

Foreword
by John Connolly

In this Review, Roger Bootle, our Economic Adviser, takes a look at whether the financial sector’s role in the economy will continue to grow and if London can remain the top global financial centre. Roger believes that the coming years will present plenty of opportunities for London’s financial hub to secure its position as world number one. The onward march of globalisation will open up a realm of new international markets which the UK can take advantage of. Indeed, there is a huge accumulation of saving in Asia that will gradually be invested around the world. As well as new markets, London has a strong track record for developing and trading new products and is the European centre for new financial services.

However, Roger admits that there are likely to be a number of challengers to London’s top position, with a key threat being the emergence of a new Asian global financial centre. Roger believes that as China and India get richer they will turn to London to fulfil their mushrooming need for international financial services. Accordingly, he thinks that rather than posing a threat, the rapid development of these countries suggests that a massive growth phase of the UK’s financial services sector is yet to come.

More generally, the big issue confronting the economy is the looming slowdown in America, and its consequences for all our major markets, including those on the continent. Roger believes that the effects here can be comparatively modest and that after a year or two, growth can bounce back to trend. Once again, I hope that this Review helps you in both your immediate and strategic thinking.

The financial services sector has been one of the UK’s biggest success stories in recent years. Not only has it punched above its weight in driving GDP growth, but it has produced a significant trade surplus for the UK.

• Much of this success derives from London’s position as the world’s leading international centre for financial services. The booms in mortgage lending and consumer credit have supported the domestic retail financial services found on the UK’s high streets.

• There is every reason to expect the financial sector to continue to take an increasing share of GDP. The onward march of globalisation opens up a realm of new international markets which the UK can take advantage of. There is a huge accumulation of saving in Asia, which will gradually be invested around the world.

• The UK’s financial sector can also expand into new product areas altogether. London has a strong track record for developing and trading new products.

• The continued success of the UK’s financial sector depends on London retaining its ability to take a high share of global financial business. But there is little reason to expect London to lose its numerous advantages over other international financial centres, such as a good regulatory system and a flexible labour market.

• New international financial centres in China and India are unlikely to take away much, if any, of the business London does with the rest of the world, given that even well-established financial centres like Paris and Frankfurt cannot match London’s comparative advantages.

• That is not to say there are no immediate risks at all for the financial services sector. Perhaps the most serious is a sharp global economic slowdown. And in the face of what is likely to be a prolonged slowdown in household borrowing growth, the domestic retail banking sector is likely to have focus its efforts elsewhere.

• Overall, though, the outlook for the UK’s financial services sector remains favourable. We expect it to continue to grow in importance, bringing increased prosperity to the UK.

• Elsewhere, the UK economy now appears to have recovered fully from last year’s soft patch. Not only has consumer spending growth regained some momentum, but other sectors are also providing a greater contribution to economic growth.

• We expect growth to slow next year as the external sector struggles in the face of a US slowdown. We expect a slowdown in UK GDP growth from 2.5% this year to just 2% next year. Even in 2008, further adjustments in the consumer and government sectors are likely to keep growth below trend at 2.5%.

• While interest rates are likely to rise further this year, we think that rates are likely to be falling by the second half of next year as the MPC responds to slowing growth and fading inflation pressures.

From strength to strength

The outlook for the UK’s financial services sector

The financial services sector is one part of the UK economy that has gone from strength to strength in recent years. Not only has it given a strong boost to GDP growth, but it has also been the area of the economy creating the biggest trade surplus.

But is this as good as it gets for the financial services industry? A number of challenges loom on the horizon. Yet a number of opportunities also present themselves. In this article, we take a closer look at whether the financial sector’s role in the UK economy will continue to grow and if London can remain the top global financial centre.

A keystone of the economy

Chart 1 shows the increasingly important role the financial services sector has been playing in the UK economy. At the start of the 1990s, the financial services sector accounted for 5% of GDP. It now accounts for 9.0%.

The strength of financial services has also had important knock-on effects to other parts of the economy. In particular, it has contributed to the strong growth seen in the wider business services sector, which includes various support services such as accountancy, legal and secretarial services. Business and financial services together account for some 27% of GDP, compared to 15% back in the late 1980s. And while the financial services sector now employs over one million people, the business services sector employs a further 3.8 million – together accounting for 18% of total employment. Of course, the financial services sector is home to a number of very different activities. 43% of employees in the sector work in banks, including both retail and investment banks. Another 26% work in financial auxiliaries. These are firms which are related to, but do not actually provide financial services, such as insurance brokers and investment advisors. 17% work in insurance and pension funds, while a further 10% work in other financial institutions, including venture capitalists, securities dealers, unit trusts and specialist mortgage lenders.

Even within these sub-sectors a wide range of activity takes place, with many firms engaging in both the retail and wholesale markets. Wholesale services, usually associated with the City of London, take place between financial institutions, banks and other large corporates, while domestic retail services are those found on the UK’s high streets.

The financial activity which takes place in London is primarily wholesale. The Corporation of London has estimated that 57% of financial employment in London is in wholesale financial services, although the fact that productivity is probably higher in wholesale than retail financial services suggests that wholesale’s share of output is higher than this.

A significant amount of wholesale activity also takes place in Scotland, reflecting Edinburgh’s position as the UK’s second most important financial sector. Edinburgh ranks second only to London in the European league table of headquarter-locations of the 30 largest banks in Europe. And its financial sector is still expanding rapidly. According to research by Scottish Financial Enterprise, the amount of funds under management by its member companies in Scotland rose to £533bn this year, a 50% rise on a year ago.

Around 55% of the UK’s financial sector activity takes place outside London and Scotland. And there is unlikely to be much wholesale activity going on in regions such as the North East. So on our calculations, it is likely that retail financial services account for somewhere between 50% and 75% of financial services output in the UK as a whole.

London – a global leader

What, then, has driven this pretty spectacular growth of the financial services industry? Both domestic and international factors have played a part. Domestically, mortgage lending has soared following the deregulation of the mortgage markets in the 1980s, the rise in home ownership (from 42% of the housing stock in 1961 to 71% currently) and the recent housing boom, which encouraged households to withdraw equity from their homes.

Unsecured lending has also risen rapidly relative to household incomes, as more sophisticated risk-scoring techniques have allowed the extension of credit to more groups of people. Indeed, similar factors mean that an upward trend in the share of financial services output in total GDP has also been the norm in other developed countries, such as the US.

As the world’s top international financial centre, London has been well placed to take advantage of rising demand for international financial services. Wholesale financial services output is estimated to have risen at an annual rate of 6% to 7% over the last ten years, compared to world GDP growth of 3% to 4%. Table 1 shows the UK’s share of the global market for different financial products, located mainly in London. The areas where it has the biggest share are highlighted in bold, with a number of points standing out about the UK’s role:

• it is the largest source and recipient of cross-border lending and has the largest share of international bond issuance;

• it is the top international equity trading location, with 43% of cross-border turnover in equities;

• it accounts for one third of all foreign exchange transactions;

• it has the third largest insurance industry after the US and Japan; and

• it is the most important market place for over-the-counter (OTC) derivatives.

London has a particularly good reputation for leading many of the innovative derivative products. For example, according to the British Bankers’ Association, its share of the credit derivatives markets stands at around 40%. It is the European centre for the newer financial services like hedge funds and private equity.

London is the most popular place for foreign banks to locate, with 264 foreign banks centred there in 2005, compared to 228 in New York. The international nature of the UK’s financial services sector is also highlighted by data from the Bank of International Settlements showing that the UK is the world’s largest single market for international banking business.

Lastly, London’s stockmarkets lead the pack. The cost of raising capital on the London Stock Exchange (LSE) is low compared to other global stockmarkets, partly reflecting low Initial Public Offering (IPO) underwriting fees. And since it started in 1995, the Alternative Investment Market (AIM) has become the world’s leading stockmarket for smaller quoted companies. AIM accounted for 52% of all European IPOs last year. The £9.4bn raised on AIM in the year to July was the equivalent of 8.5% of the £110bn of the total external finance raised by non-financial firms last year and not far off the £11.8bn raised on the LSE.

Concerns that the UK would suffer when it did not join the euro in 1999 therefore appear to have been distinctly misplaced. As the financial sector continues to grow in importance, it is important to ask what benefits it brings. Most obviously, it boosts overall economic growth. As Chart 3 shows, financial services output has risen at an average annual rate of 5.9% over the last ten years. Although it suffered two major downturns – following the East Asian currency crisis in 1997/8 and the stockmarket crash in 2000 – output bounced back quickly both times. As such, while the sector accounts for less than 10% of total GDP, it has accounted for around 16% of the growth of GDP over the last ten years.

The financial services sector has been a particularly positive force for productivity growth. There is a widespread view that the financial sector has been a strong creator of jobs. But while it is an important source of employment, the number of jobs in the sector is no higher now than it was in 2001. The recent trend towards offshoring – the relocating of back-office jobs, in particular, to cheaper countries – explains part of this. Our research suggests that 70% of major financial institutions engaged in offshoring in 2005.

So while the sector has accounted for a rising share of the economy’s output, the share of financial services jobs in total employment has been declining since the early 1990s. On our calculations, then, productivity growth in the sector has averaged 5.6% since 2000, compared to 1.8% in the economy as a whole.

Lastly, the financial services sector has been an important contributor to the UK’s trade in services surplus. As Chart 5 shows, the UK runs a trade surplus in all the main areas of financial services, from security dealing to insurance.

Indeed, the UK’s trade in services surplus of almost $35bn last year vastly outweighed that of all other countries, and was second only to Switzerland when put relative to GDP.

The UK’s surplus on its trade in financial services has therefore been an important factor offsetting part of the trade in goods deficit. The financial sector’s trade surplus equalled £18bn in 2005 as a whole – on its own offsetting around one quarter of the £67bn trade in goods deficit.

While the economy has undoubtedly benefited from the financial sector, then, the increasing dependence on it has brought some disadvantages, too.

For a start, as Chart 3 showed, the financial sector is particularly volatile. During the 1990s recession, for example, GDP fell by 2.5% from peak to trough, but financial services output fell by 6.4%. And since then, annual output growth in the sector has ranged from -1% to over 10%, while GDP has moved within the narrower range of 1.6% to 4.9%.

The concentration of financial services in London means that any further expansion of the sector is likely to put increasing pressure on London’s infrastructure. As Chart 8 shows, 17% of London’s output in 2003 was financial services, compared to the average of 7.4% across the economy as a whole in that year.

More generally, the growing financial sector threatens to exacerbate the North/South divide in terms of unemployment, incomes and house prices. Labour mobility could also be harmed, with the new jobs being created in the South far away from those being lost in the manufacturing-intensive north.

Can the rapid growth of the financial sector continue? The upward trend in its share of the economy has so far shown no sign of letting up. And there seems to be little reason to expect it to do so in the near future. Although the financial sector accounts for almost 8% of GDP, this is still some way below the 14% seen in Switzerland. And as the manufacturing sector continues its structural decline, the financial services industry is in a prime position to fill the hole. After all, since 1990, manufacturing as a share of GDP has fallen from 19% to 13.9%, a decline almost exactly mirrored by the rise in financial services from 5.2% to 9.0% of GDP.

The pace of decline of manufacturing is likely to slow at some point. In the US, manufacturing already makes up just 12% of GDP. If the UK’s manufacturing sector continues to decline at its current pace, its share of GDP would not fall to this level until 2011, suggesting that it could easily continue to decline for a few years yet. And if the financial sector continued to fill almost all of the gap left by this decline, it would account for some 10% of GDP within five years’ time.

Of course, this depends on there being sufficient demand for financial services. It is encouraging, then, that there are plenty of opportunities for financial services – particularly wholesale services – to expand, both by geography and type of product.

For a start, the onward march of globalisation opens up a realm of new international markets which the UK can take advantage of. There is a huge accumulation of saving in Asia, which will gradually become available to invest around the world – with some £2 trillion of private saving currently residing in deposit accounts in China. While the consumer lending markets in Asia are relatively undeveloped, they are growing fast.

As countries gradually remove all exchange controls, more of their populations will be able to invest and borrow money. Russia has already announced earlier this year that it is making the ruble fully convertible. Both China and India have indicated that they wish to achieve convertibility eventually.

A number of areas of international financial services stand to benefit. Cross-border lending could perhaps gain the most from the opening up of overseas financial markets. Corporate finance activity and merger and acquisition (M&A) activity could also benefit. Not only does cross-border M&A aid the transfer of technology from firms in one country to another, but it also provides an easy way for companies to seek out new markets for its products. In particular, the business acquired abroad can serve as a distribution channel for the company’s products, helping it to increase its market share abroad. Indeed, the value of acquisitions by UK firms of companies in developing countries leapt from £1.2bn in 2003 to £7.2bn in 2005.

Not only can the UK financial sector take advantage of opportunities opening up abroad, but it can also expand into new product areas altogether. The search for yield has led firms to move into increasingly risky areas, prompting a demand for new products to hedge against this risk. Meanwhile, a prime example of a new financial product being developed as conditions demand it is the "longevity bond." This allows institutions such as pension funds to hedge against the risk that life expectancy increases by more than they anticipated.

The American economist Robert Schiller argued in his recent book "The New Financial Order" that advances in technology will make it possible to trade more and more types of financial assets. He proposes a number of "new" types of risk that could be traded. One example is livelihood insurance, which would protect someone against the risk they do not earn as much as they expected. He even proposes governmental risk management, involving contracts between nations aimed at sharing the risks facing them. So countries which grow by more than expected, for example, could pay those which grow by less than expected. Crucially, London has a strong track record for developing and trading innovative new products.

Rising demand for financial services is all very well, but will London continue to take such a high share of global financial business?

London’s pre-eminent global position is down to a number of factors, some of which it is never likely to lose. These include its use of the English language and its central position between the US and Asian time-zones. Having established a dominant position in financial services early on, London has since benefited from so-called "clustering" advantages, whereby financial firms like to locate close to others in the same sector in order to gain enhanced reputation or the ability to tap into a pool of specialised labour. Even the recent trend towards offshoring (against which there is already some backlash) will not reduce the advantages of keeping the headquarters of companies in the world’s international financial centre.

Not all of London’s advantages over other international financial centres are entirely guaranteed. In a recent City of London survey, the availability of skilled labour was cited by firms as the most important factor in determining London’s competitiveness. Part of London’s advantage in this respect reflects its flexible labour laws compared to the rest of Europe. Because conditions in the financial sector can be volatile, the ease with which firms can hire and fire is an important factor for them. Another aspect of the UK’s freer labour market is its more open attitude to immigration than other European countries, helping to ensure an ample supply of labour, especially for less skilled jobs in support services, for example.

The UK is also considered to have a very good regulatory system. One of its advantages is that it has a single regulatory body, the Financial Services Authority (FSA) overseeing the industry. The US, for example, has a whole host of regulatory bodies. The UK corporate and personal tax regime is also considered relatively favourable. The highest personal tax rate in the UK is 40%, compared to 45% in Germany and 48% in France.

Looking ahead, the UK is certainly likely to retain at least some of these advantages, not least its flexible labour market. Even if the government tightens controls on immigration, it is likely to make sure it remains easy for skilled labour to come to the UK.

A bigger risk perhaps lies in the increasing complexity of the regulatory system, driven by the EU. In particular, as part of the drive to create a single market for financial services in the EU, the UK has to comply with FSAP (Financial Services Action Plan), a programme of new directives and regulations. Although the whole of the EU is subject to these regulations, there is clearly a risk that the cost of complying with them could drive business out of the EU altogether.

A second key risk is that the tax regime becomes less favourable. The Chancellor’s recent tax hikes on the North Sea oil sector demonstrate that he is not totally averse to hitting the corporate sector. Indeed, there has been plenty of speculation that banks could be subject to a windfall tax, following their recent surge in profits.

The sector could also be damaged by any change in the tax treatment of overseas nationals. Those not resident in the UK – i.e. live in the UK for less than 183 days a year – only pay tax on the income they earned while in the UK. The 2006 Budget yet again stated that "the government is continuing to review the residence and domicile rules as they affect the taxation of individuals" – a review originally announced in 2002.

Indeed, with much of the UK’s wholesale financial business owned by non-UK institutions, there is perhaps a greater risk that these firms move out of the UK altogether in response to a less favourable tax or regulatory regime, especially given the ease of mobility of both capital and labour these days.

It looks as if London has beaten off the supposed threat from Frankfurt and Paris. But now London – and indeed the other leading financial centres in Europe and the US – is facing increasing competition from further afield. For example, the UAE recently opened its banking sector to foreign banks, with Dubai offering tax-free operations to win business, leaving it well-placed to increase its share of markets in the Middle East in particular.

By far the biggest threat is the emergence of an Asian global financial centre. At the moment, the top three regional financial centres in Asia aspiring to be global centres are Singapore, Tokyo and Hong Kong. Shanghai and Beijing are expected to replace these in importance within the next few years. Hong Kong is expected to be sidelined as more Chinese business is channelled through China itself, while Tokyo is seen to be weighed down by poor regulation and heavy bureaucracy.

The emergence of China will take some time and is more of a longterm threat. The Chinese financial sector is very much still developing – firms were only allowed to trade derivatives for the first time last year, for example. Even Shanghai’s political leadership has set a time-frame of between 10 and 20 years for achieving international financial centre status. Although China certainly has a number of advantages – including strong macroeconomic growth, strategic access to markets and cheap inputs – it still has to overcome problems of a shortage of skilled labour and the lack of political and economic freedom.

We highly doubt that China will take away much, if any, of the business London does with the rest of the world. Not only is China unlikely to develop the expertise or experience that London has, but it will not have the reputation, credibility or clustering advantages that London has. Indeed, if well established financial centres like Paris and Frankfurt cannot match London’s comparative advantages, it is highly doubtful that brand new financial centres can.

In fact, if anything, as countries such as China and India get richer, they will turn to London to fulfil their mushrooming need for international financial services. Rather than posing a threat, then, the rapid development of these countries suggests that a massive growth phase of the UK’s financial services sector is yet to come.

That’s not to say that there are no immediate risks at all, however, with one of the most obvious being a sharp global economic slowdown. The head of the FSA warned earlier this year that the recent increase in exposure to risk meant that there was an increased threat of a sharp and potentially coincident correction in a number of asset classes and areas.

The FSA also warned that problems in the financial markets – such as splits, precipice bonds and endowment mortgages – have always tended to have originated during strong markets. So we might not find out what the downside risks to recently developed complex financial products are until we see a downturn in economic conditions. Meanwhile, increased technology brings greater scope for risk management – but also other disadvantages, such as increased fraud, which threaten to undermine London’s credibility.

Perhaps the biggest challenge facing the financial sector, though, is in the domestic retail arena. The retail banks have had a good time of it in the last few years, not least due to the buoyancy of the consumer sector. But the recent downturn in the consumer sector has brought with it a slowdown in the growth of borrowing and a rise in the level of bad debt, especially with respect to credit card lending.

Part of this might be cyclical and of course the rise in bad debts should not concern banks if they have anticipated it and priced their margins accordingly. But at least part is probably a reflection of the fact that total debt servicing costs are now at a record high as a proportion of income. As such, borrowing growth might stay subdued for a long while yet. And the fact that lenders have tightening their lending criteria in response to rising bad debt suggests it is unlikely that they will turn to sub-prime lending to drive growth instead.

The sector could suffer the double whammy of slower volumes growth and squeezed margins. Not only has internet banking increased competitive pressures, but supermarkets have also joined the fray.

One option for banks is to focus their attention on lending to the non-financial corporate sector instead. But the corporate sector is still pretty indebted itself. What’s more, while banks have benefited from strong lending to the commercial property sector in the last few years, this also looks set to slow given the low level of yields on commercial property.

Perhaps, then, banks will have to shift their energies away from lending altogether. With households’ attention turning to saving – especially for their old age – perhaps the best opportunities for retail banks are in the long-term savings market instead.

The outlook for the UK’s financial services sector remains pretty favourable. The potential competition from the financial centres emerging in Asia, especially China, poses some threat. But it is important to remember that the opening of these markets presents key opportunities for the UK as well.

Of course, other threats remain, not least a sharper than expected slowdown in global growth. And different parts of financial services will have very different experiences, with the domestic retail banking sector perhaps set to face the hardest time.

Nonetheless, we expect the financial services sector to continue to grow in importance, bringing increased prosperity to the UK.

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