London Shrinks Faster Than Any Financial Center as Banks Come Under Attack

London’s Square Mile is shrinking faster than any financial center in the world.

Having fired more employees than in any other country last year, the capital’s banks are facing falling trading revenue, attacks from politicians to reduce pay and more job cuts. The U.K. government wants banks to split their consumer and investment banking units while European Union leaders are pushing to tax individual trades by the end of this year.

“We’re going to end up with a smaller, more focused financial sector,” said Michael Kirkwood, 64, former head of Citigroup Inc. (C)’s U.K. division, who began his career in the Square Mile in 1965. “The entire financial world became too bloated in the run up to the financial crisis, and London was excessively bloated.”

London, the world’s biggest center for foreign-exchange trading, cross-border bank lending and interest-rate derivatives, is being squeezed by both the impact of the European sovereign-debt crisis on demand for its services and politicians who blame financiers for bringing the world economy to the brink of collapse. Banks are responding to the Basel Committee on Banking Supervision’s latest rules by exiting capital-intensive activities such as proprietary trading, putting at risk the U.K.’s biggest exporting industry and 12 percent of its tax receipts.

RBS Cuts 3,500

“Most of the main sales and trading desks in Europe, Middle East and Africa are here,” said Philip Keevil, a former head of North American investment banking at S.G. Warburg & Co. and now a partner at New York-based advisory firm Compass Advisers LLP. “Insofar as global banks have to make cuts in these areas because of Basel III and other regulations, then the cuts will be in London.”

Royal Bank of Scotland Group Plc, which got the world’s biggest bank bailout, said last week it will close its equities and corporate finance units, cutting as many as 3,500 jobs. The division is unprofitable and the bank will “reduce in areas where capital intensity is high,” it said. RBS has already cut 30,000 jobs since it was bailed out by the government in 2008 and 2009, costing 45.5 billion pounds ($69.7 billion).

U.K. Cutbacks

U.K. financial-services firms eliminated 58,000 jobs last year, more than any other country in the world and 45 percent of the cutbacks announced by all western European banks, according to data compiled by Bloomberg. The numbers include worldwide cuts by U.K.-based financial companies such as HSBC Holdings Plc (HSBA) and exclude reductions in London by overseas banks such as Credit Suisse Group AG.

Employment for London’s bankers dropped 8.5 percent last year compared with 2010 and over the next two years will remain below 1998 levels, according to the Centre for Economics & Business Research Ltd. U.S finance jobs dropped 1.7 percent in the same period, according to headhunting firm Challenger, Gray & Christmas Inc., citing U.S. Bureau of Labor Statistics.

The industry’s contribution to U.K. gross domestic product shrank from 2009 to 2010, the first time in a decade, according to TheCityUK, a lobby group, which cited data from the Office of National Statistics. Financial services dropped to 8.9 percent of GDP in 2010, the latest data available, from 10.1 percent in 2009. That’s still up from 5.2 percent of GDP in 2000.

“The whole industry needs to be consolidated and needs to be shrunk,” said John Mann, a Labour Party lawmaker. “It’s too powerful. That is to the huge detriment of the long-term sustainability of economic growth in this country.”

Tax Revenue Declines

The shrinking financial sector is lowering Britain’s tax revenue, according to TheCityUK. Financial services paid 63 billion pounds in taxes last year, or 12 percent of total revenue, it said, citing data from PricewaterhouseCoopers LLP and the City of London Corporation. That’s down from 2007, when the industry contributed 14 percent of tax receipts.

Tax revenue is being squeezed because banks are making lower profits. Basel III’s capital and liquidity rules will cut investment banks’ return on equity to 7 percent from 20 percent, according to a report by New York-based McKinsey & Co. published in September. That will reduce profit after tax to $30 billion from $40 billion for the biggest 13 banks, it said.

“Institutions that aren’t in the top positions in certain products will begin to exit those products,” said Giles Williams, head of KPMG LLP’s financial-services regulatory center of excellence in London. “Banks will focus on what they are good at and what they’re famous for.”

Proprietary trading in fixed income, commodities and derivatives markets may be the worst affected by the extra capital requirements, Williams said.

UBS Cuts 2,000

“Trying to reduce the capital impact is clearly an aim for many of the banks,” said Ian Baggs, global banking and capital markets deputy leader at Ernst & Young LLP in London. Banks are focusing on achieving a high volume of trades with client money in markets such as interest-rate swaps rather than proprietary trading, which uses the bank’s own money to take positions and carries a high regulatory capital requirement, he said.

UBS AG (UBSN), hit by a $2.3 billion trading loss in London, announced a plan in November to shrink its investment bank to focus on wealth management at a cost of 2,000 jobs. It plans to exit asset securitization, complex structured products, macro- directional trading and equity proprietary trading. The investment bank’s European headquarters is in London and it employs about 7,000 people in the U.K.

Smaller Stockbrokers

In the first quarter of last year, bank executives were planning to cut costs by 10 percent to 15 percent to boost return on equity targets, Ernst & Young’s Baggs said. Now they’re targeting 40 percent cost reductions, he said.

Clients’ aversion to risk amid the turmoil in Europe is also squeezing equity trading desks and smaller stockbrokers in particular. Average trading volumes on the London Stock Exchange has remained below pre-crisis levels, according to data compiled by Bloomberg.

Morgan Stanley’s heads of European credit sales and trading, emerging market fixed-income sales and trading departed as well as two managing directors at its equities unit in London. Nomura Holdings Inc. (8604) is also scaling back its European expansion that began after the purchase of Lehman Brothers Holdings Inc. (LEH)’s European and Asian units in 2008.

Stockbrokers Evolution Group Plc (EVG), Merchant Securities Group Plc, Arbuthnot Securities Ltd. and Collins Stewart Hawkpoint Plc (CSHP) have all accepted takeover offers from larger competitors since the end of October.

Economic Forecasts Reduced

“For firms that have revenue falling off a cliff with a large cost base, the future is very bleak,” said Jamie Moyes, who worked in sales trading at London-based brokerage Liberum Capital Ltd. until September. “The events of the market place are horrendous.” Moyes plans to help set up a stockbroking firm, starting with about six partners.

Aside from trading, equity capital markets and merger and acquisition advisory teams are also being slimmed down as a result of lower demand from corporate clients because of the European sovereign-debt crisis and worsening economic outlook.

The euro-region economy may expand 0.3 percent in 2012 instead of a previously forecast 1.3 percent, the European Central Bank said on Dec. 8. Some forecasters, including Morgan Stanley, project the region will shrink this year.

Firms in the U.K. raised 9.7 billion euros ($12.4 billion) through share sales last year compared with 24.9 billion euros in 2010 and 71.4 billion euros in 2009, according to data compiled by Bloomberg.

Bonuses Decline

The reduced corporate activity is affecting pay. Bonuses paid to the average London financial services worker for 2011 may shrink by about a fifth to 19,920 pounds, or 24 percent of their base salary, according to a survey by recruitment firm Astbury Marsden.

While London’s banks have survived declines before, their profitability is under a fresh attack from international regulators. The European Commission, which drafts legislation for the European Union, has proposed a transaction tax of 0.1 percent on trading of stocks and bonds, and a 0.01 percent rate for derivatives contracts.

U.K. Chancellor of the Exchequer George Osborne called the tax “a bullet aimed at the heart of London” and estimates as much as 80 percent of the revenue raised will come from U.K. firms. French President Nicolas Sarkozy said last week he’s willing to impose the levy unilaterally in an effort to spur other countries to join.

Transaction Tax

The European Commission estimates the tax on its own could raise 57 billion euros a year. That’s optimistic because it excludes the impact of lower capital-gains tax revenue and gross domestic product, a study by Ernst & Young said this month.

The tax will increase transaction costs in the foreign- exchange market by three to seven times and by as much as 18 times for the most traded parts of the market, a study by Oliver Wyman commissioned by the Global Financial Markets Association said today.

U.K. Prime Minister David Cameron insists Britain can veto the EU tax, meaning countries within the 17-nation euro area may need to introduce the levy on their own. That may still put pressure on Britain should euro-region countries impose the tax on euro-denominated products.

Talking Tough

European parliamentarians have also suggested rules to force clearinghouses that handle euro-denominated securities to be based within the euro region, prompting the U.K. to sue the European Central Bank, saying the plan would compromise free markets. London is home to 40 percent of the world’s over-the- counter derivatives trades and LCH Clearnet Group Ltd., Europe’s biggest clearinghouse.

While defending London’s financial interests in Europe, the U.K. government has been talking tough on the industry at home, where unemployment is at a 17-year high and the economy has struggled to grow following the financial crisis four years ago.

Cameron used his first speech of the New Year to pledge an end to bankers’ “excess” while Osborne said last week the industry should be a “smaller slice” of the economy.

Cameron’s government last year accepted proposals from the Independent Commission on Banking to force banks to insulate their consumer banking units while increasing capital requirements. Those recommendations will cost banks as much as 7 billion pounds annually to implement, the panel said.

Barclays, HSBC

Among the U.K. banks, the proposals will affect lenders with investment banking divisions the most and Lloyds Banking Group Plc (LLOY) the least because it is mainly a retail bank, according to analysts at HSBC Global Research on Jan. 10. HSBC, RBS and Barclays Plc (BARC) all have investment banks.

London’s decline puts its status as the world’s premier financial center under threat from New York and Hong Kong, which are catching up, according to a survey of 1,887 executives by financial-services research firm Z/Yen, published in September. The survey asked about issues such as regulation, tax and lifestyle.

“London may not always be number one in the world, but it will still be a strong financial center,” said Mark Yeandle, Z/Yen’s associate director in London. “It’s not going to fall out of the top five anytime soon.”

London’s Advantages

London’s strengths include its depth of expertise, time zone, language and legal infrastructure, according to Z/Yen. It is home to 241 foreign banks, more than in any other country, the biggest foreign-exchange market and the largest market for interest-rate derivatives, with $1.4 trillion of daily revenue, or 46 percent of the world’s total, according to the Bank for International Settlements.

Ten years ago, London’s bankers were dealing with the bursting of the dot-com bubble and were concerned the City would be left behind as Europe began trading its single currency. It went on to have its most profitable five years on record. This time, bankers say they’re hoping history repeats itself.

The second half of 2011 “was the worst I can remember in my career because we moved from a financial crisis to a sovereign-debt crisis,” said Robert James, an analyst of financial stocks at Aviva Plc (AV/) who has worked in London for 22 years. “Now the realization has dawned on the politicians that they have to do something about it. That has to be a good thing for 2012.”

To contact the reporters on this story: Kevin Crowley in London at kcrowley1@bloomberg.net; Ambereen Choudhury in London at achoudhury@bloomberg.net

To contact the editor responsible for this story: Edward Evans at eevans3@bloomberg.net;

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