The City Of LondonStanley Reed
It has reclaimed its status as a financial mecca, thanks to Europe's exploding demand for investment services
A year ago, Timothy Grell was working in Merrill Lynch & Co.'s Wall Street offices, dreaming up creative financing packages. Now his lanky frame can be found on the fixed-income trading floor of Merrill's sprawling European headquarters in the City of London. Leading a 19-member team, he's preaching the virtues of junk debt to a receptive audience of European companies and fund managers. Since April, 1997, when Merrill introduced the first European currency junk bond for Geberit Group, a Swiss maker of plumbing supplies, "the market has really taken off," says Grell, 40, who is so busy lately that he barely has time for his newborn son.
Grell is one of thousands of financial professionals from the U.S., Asia, and Europe who are flocking to the City, the financial district in the ancient heart of London. Like the Barings, who came to Britain in the 18th century from Bremen, and Nathan Mayer Rothschild, the Frankfurter who called the tune in the City in the early 19th century, these new financiers bring much-needed ideas. This time, the charge is being led by U.S. banks and investment houses, which are using their record profits on Wall Street to pave the way for aggressive expansion abroad. Followed closely by European institutions that see their future in investment banking, these financial giants are bringing a massive infusion of capital and technology to a City that until the late 1980s was becoming dangerously parochial.
The City's reawakening is part of a seismic shift in European economic, social, and political attitudes. A new equity culture is developing across Eastern and Western Europe as citizens realize that their cash-strapped governments will no longer be able to provide for their retirements. That change will mean a surge in demand for mutual funds and other investments for City firms to create and manage. A new generation of profit-driven managers and activist shareholders, meanwhile, is demanding that European corporations improve their performance. To do so, corporations are searching for cheaper and more creative sources of financing. That means huge new quantities of equity and debt for City firms to underwrite (charts, page 45).
HOT GROWTH. Not even Britain's decision to stay out of the European Monetary Union for the next few years seems likely to hurt the City's prospects of becoming the preeminent financial center in Europe and, perhaps, worldwide. For now, bankers aren't worried about Britain's reluctance to join EMU. Perhaps that view will change if, 10 or 20 years from now, Britain were still out and isolation made doing business in Europe difficult. But most bankers assume that Britain will join EMU before then--or the system will have collapsed.
In the meantime, City bankers are rubbing their hands over the prospect that European financial services may turn in hotter growth than those in the U.S. over the next two decades. Sallie L. Krawcheck, an analyst at New York's Sanford C. Bernstein & Co., estimates that with private pensions and mutual funds growing at a 30% annual clip in some European countries, the overall equities and investment banking business will grow 15% annually for the next five years. That's twice the rate of growth expected in the U.S. Financial services account for 25% of Britain's gross domestic product and employ 4 million people.
Banks are drawn to the City's fortuitous time zone, supportive regulation, and a deeply ingrained risk-taking culture that has survived spectacular crises. Barings, for instance, nearly went under in 1887 after underwriting projects in Argentina. More than a century later, Barings was toppled by a rogue trader in Asia--only to be reborn as a unit of Amsterdam's ING banking and insurance group.
In the rush to remake the City to serve a new Europe, most of the local merchant banks that once dominated corporate finance in London have been taken over by foreign firms. The surge of international investment has improved the City's game. Indeed, it is "a great source of strength," says Bank of England Governor Eddie George, noting that the recent arrivals "bring new ideas and innovations," as well as "international connections." To be sure, the majority of City workers remain Londoners, who took home a hefty share of the $1.6 billion in bonuses paid out last year. But proud names such as Warburg and Morgan Grenfell are in foreign hands. Dozens of smaller firms were swallowed up by bigger fish after the 1986 event known as Big Bang. Pushed by then-Prime Minister Margaret Thatcher, Big Bang abolished minimum commissions and opened up membership in the clubby London Stock Exchange.
The invasion of foreign banks--565 of them now have offices in London--is one reason a third of the cramped City has been rebuilt in the past two decades. Eager for more space, bankers are moving into Canary Wharf, the massive real estate project on the Thames. Paul Reichmann's glass complex, which went into receivership in 1992, now looks like a roaring success. A record 1 million square feet of office space was rented out in Canary Wharf in the last year, and Citibank is putting up a new building.
This isn't the first time the City has burst forth on the global stage. It has been a big-time financial entrepit for centuries, thanks initially to British naval power and mercantile dominance. In the 18th century, merchants sold cargoes of tortoiseshell, spices, and timber in smoky coffeehouses. From their credit needs grew a thriving merchant banking and securities industry. By the 19th century, London was the undisputed center of the commercial world. Its denizens made and lost fortunes financing not only trade but a global surge in industry, including America's railroads and southern Africa's gold mines. Walking the City's winding passages, it's easy to imagine the district's famous fictional resident, Ebenezer Scrooge, turning a corner.
The City's stature declined this century as Britain lost its empire and fell into an introspective funk. But the creation of the Eurobond market in the late 1960s, as banks flocked to London to circumvent U.S. capital restrictions, started reviving the City's fortunes. The prospect of a single European currency and the current bull market in stocks, mergers, and acquisitions, has helped the City regain its former clout.
Now London dominates trading in international equities and does about $460 billion daily in foreign-exchange transactions. City bankers lead the world in cross-border loans, with some $1.5 trillion outstanding. The City is also a powerful force in the fast-growing derivatives industry. And many financial institutions have made London their command post for the big investments they plan for such emerging markets as Russia, Poland, Turkey, and South Africa.
BONANZA. Still, when financiers size up the Continent, they see what may be one of the greatest financial opportunities of all time. Europe has a larger economy than the U.S., with a GDP of nearly $9 trillion, vs. $7.6 trillion for America. Yet outside of Britain, Europe's capital markets remain largely undeveloped. In contrast to the U.S., where corporate bonds and equities drive most company financing, Europeans are still largely restricted to borrowing from banks. In addition, most European investors are skeptical of stocks, let alone high-yield debt. The combined value of Europe's stock markets is equivalent to only 75% of its GDP, vs. 154% in the U.S.
The potential revenues and fees to be gained by opening up European markets are enormous. Institutional investments in Britain, Germany, France, Italy, and Spain total $5.2 trillion now. That's equivalent to 77% of their GDP, says Bernstein's Krawcheck. America's $13.6 trillion in institutional investments, by contrast, are equal to 189% of its GDP. If European assets under management approached anywhere near a similar proportion of the economy's size, an additional $10 billion in money management fees could roll into the City's banks. Europe's increasingly important corporate debt market could produce as much as $700 billion in new paper per year within five years, says Bill Winters, head of European fixed income at J.P. Morgan & Co. in London.
But even as they ponder these enormous sums, bankers already are making big money helping European companies merge. With more and more businesses disposing of underperforming assets and buying other companies to position themselves for EMU, the value of European mergers increased 20% last year, to $326 billion, says Securities Data Co. That's one reason the City's 1997 bonuses jumped an estimated 20% to 25%, say human resources experts.
The prospect of further rich pickings is why Goldman, Sachs built a gleaming tower on Fleet Street, where newspaper reporters used to roam, and why Merrill Lynch is constructing an office block for 5,500 workers by 2001. These and other major institutions also have big offices in Frankfurt, Paris, and elsewhere on the Continent. But key executives sit in London. Says one investment banker: "When we need firepower, we put people on a plane from London."
Even the new European Central Bank's Frankfurt base is unlikely to diminish London's importance. Just as in the U.S., where monetary policy is set by the Federal Reserve Board in Washington and traded upon by banks in New York, the European money market may split. "London will be the largest center for euro trading in foreign exchange, swaps, and government bonds," predicts J.P. Morgan's Winters.
Frankfurt isn't conceding defeat. Its electronic futures market now dominates trading of the German long bond contract--a position once held by the floor traders on the London International Financial Futures Exchange. But if the euro is overregulated, the Continental traders' gains will be eroded and more business will go to London.
The City will need more deals to support its lavish pay packages. Big European and American firms in London are competing on a level playing field, which has driven up compensation costs toward U.S. levels. Top rainmakers at U.S. banks in London are said to earn $1 million to $3 million. Although the City's costs are around 65% of those on Wall Street, compensation has been rising quickly. That's putting pressure on British investment banks, whose return on equity has averaged just 4%. "We have imported pay scales that the revenues don't justify," says David Mayhew, a partner at the British brokers Cazenove & Co.
PLAYING CATCH-UP. Although European institutions have the advantages of long-standing client rosters and strong balance sheets, that may not be enough. The Americans boast wide access to U.S. investors, something no Europeans have. And unlike their U.S. competitors, most of the European banks have been serious players only in their home markets. To compete in the new global economy, they'll need to make up for lost time. For years, they could show minuscule returns in investment banking without drawing shareholder ire. Until recently, Deutsche Bank didn't think return on capital should factor into its investment decisions, says a knowledgeable source.
After watching the Americans build up their City operations in the early 1990s, Barclays Bank, Deutsche Bank, and National Westminster Bank tried to match them. So far, however, it has been no contest. The only Europeans to make a big splash have been SBC Warburg Dillon Read, an amalgamation of several institutions in Britain, Switzerland, and the U.S., and the Lazard houses. Lazard ranked second, between Morgan Stanley, Dean Witter, Discover & Co. and Goldman Sachs, in European mergers last year. "My friends thought I made a mistake," says a Briton who joined Goldman Sachs in the 1980s. "Now they all wish they were here."
European banks are paying a stiff price for ratcheting up costs without delivering good profits. The consolidation wave is easing some of the pressure that has made compensation skyrocket. Barclays and NatWest have sold off their investment banking units. The departure on Mar. 6 of the well-regarded ING Barings markets chief, Peter Geraghty, may signal cutbacks in the Dutch bank's securities arm. Barings recently chopped 200 jobs in Latin America and Asia. And SBC Warburg will lose 2,000 of the 3,000 London-based employees of its new partner, the former Union Bank of Switzerland.
Despite the competition, Merrill Lynch saw enough potential in Europe to pay $5.3 billion, or a stunning 25 times earnings, for London's Mercury Asset Management Group in 1997. Merrill intends to use Mercury as a platform to provide mutual funds and other services to European investors, as well as new international products for Americans. "The price we paid was a full one," says Michael J.P. Marks, Merrill's executive chairman for Europe. "But we didn't think we could build a business fast enough to take advantage of EMU and the changes in European pensions."
There are some clouds on the City's horizon. Monetary union will have some disruptive consequences. The chaos expected from the switch from individual currency-denominated bonds to euro instruments could sharply decrease issuance. Another banking mainstay, foreign-exchange trading, is likely to wither away---although London, which dominates European dollar and yen trading, is not likely to suffer as much as Frankfurt and Paris, which depend heavily on European currency trading. More worrisome is that so many City-based banks have similar strategies and expectations for Europe. "If you add up the market share everybody thinks they have to gain, it probably comes up to 200% of the likely business," says a skeptical banker.
All this means more competition and pricing pressure. Price-cutting has made European privatizations a much less attractive business for bankers. And a bear market could dry up the mergers and equity underwriting deals overnight and produce massive layoffs. But no one's thinking bear market now. As Europe gets ready for the euro, London's dealmakers are still relishing their new golden age.