GaWC Research Bulletin 60 |
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This Research Bulletin has been published in Journal of Economic Geography, 2 (4), (2002), 433-453 under the title 'London in the European Financial Services Industry: Locational Advantage and Product Complementarities'.
INTRODUCTIONMore than 130 years ago, Bagehot (1873, 330) lauded the vitality of the City of London. Referencing Paris, he predicted that London would maintain its "natural pre-eminence" as the "clearing house" of the world. For Bagehot, London's growth could be traced to the reform Act of 1844, which effectively created a market for credit. More recently, Smith and Walter (1997, 302) suggested that the (current) pre-eminence of London in Europe can be traced to the UK Financial Securities Act of 1986 which effectively liberalised the market for private securities' transactions. Even if Wall Street is much larger in terms of domestic traded volume, listed securities and total assets, London dominates cross-border transactions and is the favoured location of many foreign banks and market intermediaries. London and New York represent in space the dominant global financial system of the late twentieth and twenty-first centuries.1 Their relationship is at once competitive and reciprocal, being joined together by a common legal and economic heritage (cf. continental Europe; see La Porta et al. 1998). The continued success of London is a matter of enormous importance for the UK economy (GDP, trade, employment and income) (IFSL 2001). Nonetheless, the dominance of London (and the south-east in general) has prompted re-current geographical and sectoral tensions; the growth of regional income and employment inequalities over the past twenty years or so has been linked to the concentrated economic and political power of City financial institutions (Martin and Minns 1995). Likewise, the role of London in the emerging European single market for financial services has prompted considerable debate in Europe. Ironically, the Franco-German alliance that has driven monetary union and the Euro, has been mediated and priced in the London and New York markets (Szasz 1999). Political claims for respect for nation-state financial systems have been directly challenged by the economic opinions and power of these markets. Whereas some suppose that competition between European financial systems is unresolved, it is arguable that London has re-affirmed its dominance over Frankfurt and Paris over the past ten years (compare Story and Walter 1997). More specifically, research on continental European social-security systems suggests that Anglo-American financial markets will play increasingly important roles in the investment of retirement income assets. This much is apparent from the structure and performance of the Dutch and Swiss pension systems. But it is also apparent in France and Germany. The introduction in both countries of state-codified private retirement savings instruments implies the discounting of the long-term value of state-sponsored social security benefits; private arrangements will be required to make-up the difference (Clark 2002a). While these institutions are not like Anglo-American funded pension plans, the long-term retirement income of many European citizens will depend upon the cost efficiency and investment performance of these private savings institutions. In this regard, London looms large: as the dominant European centre of financial expertise and as the most obvious market through which to mobilise pension and savings assets for global investment. Recent moves by the European Union to develop a single market regulatory framework for pension and retirement income products suggests that London may well continue to grow in significance relative to Frankfurt and Paris. My goal is to explain how and why London occupies such a vital role in the European and global financial services industries. In doing so, I focus upon the production of financial products relevant to the retirement incomes of European citizens. As should be appreciated, this focus is important in its own right and is illustrative of the scope and complexity of financial products produced in London. Notice, however, that I draw a distinction in principle if not entirely in fact between the geography of financial production and the geography of financial trading. It seems likely that financial trading will be increasingly concentrated in fewer markets as electronic communication and trading systems replace trading floors and market-places (Laulajainen 2001). Consolidation in European financial markets is one expression of the increasing significance of such technologies, just as European Monetary Union and the introduction of the Euro have provided strong imperatives for integration. Pan-European and even trans-Atlantic trading platforms may become a reality in the next five to ten years. This does not mean that financial products will be also produced in virtual space, nor does it mean that virtual markets will necessarily overcome existing and deeply-entrenched differences between jurisdictions in their regulatory cultures, instruments and standards of accountability. Compare the comments of Duisenberg (2001) on the supposed hyper-reality of finance with the more careful assessment provided by the Bank of International Settlements (2001, pp. 4-5). To sustain my argument, I use material gleaned from intensive interviews with UK, US and European financial institutions focusing upon the competitive dynamics of the financial services industry, the nature of financial products, and the distinctive place of London in 24-hour global financial trading and transaction systems.2 Having developed an analytical perspective on these issues, I focus upon the long-term spatial configuration of the European single market for financial services. It should be acknowledged that this issue is the subject of considerable academic and policy debate. I do not intend to cover all the relevant literature. Nor do I intend to engage or in any sense qualify the extensive and detailed historical treatments of the topic.3 Rather my perspective is analytical and informed by recent developments in economic geography. At the same time, I take seriously the history and geography of London in relation to Europe and global markets. Even so, by focusing upon the production of financial products I hope to show that history and geography are contingent on the actions and interests of economic agents. Invoked are economic concepts like product range and threshold just as I consider the importance of agglomeration economies, increasing returns and path dependence allied with economic geography. To do otherwise would be to impose space and time on agents rather than seeing both adapted and produced through the actions of agents. CATEGORIES AND CONCEPTSThere are a variety of ways of approaching the topic.4 In geography, attention has been paid to differences in the local informal customs and norms regulating market transactions (and hence sustaining spatial differentiation). Consequently, there are studies that assess the distinctive cultural milieu and transactional relationships that characterise the City of London (see for example Amin and Thrift 1992). Appreciation of the cultural rudiments of industry organisation is one expression of a consistent interest in the changing nature of firm and industry organisation as they affect the geographical configuration of production (in general) and the tensions between localisation and globalisation (in particular). In fact, economic geographers have paid far closer attention to the internal organisation of firms and industries than economists similarly interested in the economic geography of contemporary economies. At the limit, there are interesting overlaps between the disciplines of economic geography and finance. Witness the work of geographers on the management of modern corporations (O'Neill 2001 and Schoenberger 2001). By contrast, economists interested in economic geography have sought to develop and explicate the spatial implications of golden rules. Krugman's (1991) argument about the significance of increasing returns for the localisation of agglomeration economies has provided a macro-economic logic for understanding the differentiation of the economic landscape. Assuming an initial (arbitrary) assignment of economic activity, increasing returns allows for the cumulative development of places along distinctive paths of accumulation that tend to persist notwithstanding the arbitrage mechanisms of an equilibrating spatial economic system. In terms of industry organisation, one implication from this kind of analytical perspective is the evolution of specialised industry-regions, industrial districts and the like. Put slightly differently "there is a priori a great deal of flexibility in the choice of locations but a strong rigidity of spatial structures once the process of agglomeration has started" (Ottaviano and Thisse 2001, 177). In this sense, London can be seen as an instance wherein an initial advantage has become a dominant process. History matters even if there is unease about the predictive force of the new economic geography. In this paper, I focus upon the micro-economic imperatives driving firm location decision-making in the context of an inherited European and global landscape. This allows us some flexibility with respect to the behavioural logic that we might attribute to corporate decision makers. One disadvantage of the golden-rule approach of Krugman and others is the necessity of assuming a rational signal-response mode of decision-making (as shown in Arthur (1992) and elsewhere). At the same time, I am not convinced that the inherited landscape is as compelling as assumed by those that believe in path dependence. Firms assess and re-assess time after time the costs and benefits of particular locations. This is especially true of the Anglo-American "bulge-bracket" financial houses that maintain and manage their global operations on a daily basis through advanced information and communication technologies. Basically, the analytical approach I use is focused upon the production of financial products (or services) drawing upon previous arguments provided, in part, in Clark (2000) and Clark and O'Connor (1997). Firms and Industry CompetitionLet us begin with the objective function of financial service firms. It is assumed that these firms maximise reported income, being sensitive to the link between reported income and the quoted stock market prices of their parent institutions. It is also assumed that corporate managers tend to protect against "negative surprises" in reported income, managing expectations about the flow of reported income quarter-to-quarter and year-to-year. At the senior level, it is further assumed that corporate executives' compensation packages are tied (in part) to changes in stock market prices. But it is assumed that lower down in the corporate hierarchy the cost of employment packages is a significant factor in managing reported income. While we assume that these firms manage reported income, we should also assume that there are strong incentives to minimise the costs of production (one important component being labour costs). Finally, it should be apparent that there are significant agency issues both between senior managers and stockholders, and between senior managers and employees. Executing corporate strategy requires a level of active management that can be very hard to sustain down the corporate hierarchy. It is also assumed that acknowledged expertise and demonstrated track records of success are at a premium in the industry. The combination of reputation and consistency of outcomes drives the prices that firms can charge for their financial services. However, it should be acknowledged that the outcomes of investment management (for example) are only revealed at the end of regular periods of time. In many cases, the value of any financial product is predicted against an accepted benchmark rather than guaranteed (Shleifer 1985). Consequently, while firms may accumulate clients and mandates for the provision of financial services on the basis of their past performance, the competitiveness of financial firms is very sensitive to their relative performance. Consistently poor relative performance can prompt sudden and sustained client defection, the loss of mandates, and the discounting of hard-earned reputations. Not only is reputation a vital means of attracting talented employees and clients, it drives the accumulation of financial assets so important for reaping firm-specific economies of scale (Clark 2000, Ch. 4). For a variety of reasons, the industry is dominated by a relatively small number of very large multi-jurisdictional and multi-functional firms. At the same time, there are a myriad of small, highly specialised firms providing distinctive and particular sets of skills and services to large firms and to the market in general. Competition is rife in the industry. The potential entry and exit of rival firms combined with the predatory employment and prices practices of the larger firms drives corporate strategy. Witness, for example, the flow of mergers and acquisitions over the past 10 years, the spin-out firms created by those leaving larger firms, and the impact of technology on the costs and quality of service provision. In part, scale economies are important because they allow firms to spread the cost of product innovation, recurrent investment in information technology (year to year), and the costs of managing reputation in the global marketplace. However, economies of scale are not so important that they can insulate dominant firms from poor relative performance. In fact, the growth of US firms through the acquisition of UK firms is an indication of the costs of complacency and inertia. In sum, the financial services industry is characterised by oligopolistic behaviour and competition. Following Waterson (1984, 17), "the quintessential feature of an oligopoly is interdependence: the actions of all the individual firms in an industry are affected by the actions of the other firms." Equally important, of course, is product differentiation (see Viscusi et al. 1997). This is a vital component of most firms' competitive policy, being driven by inter-firm rivalry as well as by those who demand increasingly specialised and tailored financial products. London and Industry OrganisationLondon's financial industry is much more than the City of London. It has spilled out towards the west-end of London and in recent years it has been joined by massive developments at Canary Wharf (to the east). It is now a set of related nodes spread across London, and a set of isolated locational choices connected to systems of national and international communication and transportation rather than immediate market relationships. Whereas much of the economic geography literature on industrial districts assumes an intimate connection between the citizenship of firms and their location, London is an "industrial district" that has attracted and retained firms whose home location could place them elsewhere in the world (in the US and Europe, for example). Indeed, for many such firms, locating and developing a significant presence in London has been a conscious locational choice made both in relation to competitors and related firms, and in relation to the preferences and needs of customers. London relies upon four rather different but overlapping markets. The domestic UK market is very significant. The volume of institutional and pension fund assets is very significant, being ranked third in the world after the United States and Japan (in that order) (Davis and Steil 2001). When compared to continental Europe, this element is sufficient to distinguish the UK economy and London (its financial hub) as a profoundly different type of financial system (Davis 1995). A second, most important, market is the interchange between the US and Europe, facilitating and mediating a wide range of transactions flowing from Europe to the United States and from the United States to Europe. This is a traditional function provided by the City of London; it represents a market that is global in scope, joining-up as well London with Asia, Asia with Europe and the Americas. A third important market is to be found in continental Europe. London provides financial products and services not found in continental markets, or financial services provided in London by institutions with acknowledged superior reputations and costs and prices. A fourth important market is the rest of the world; private and sovereign institutions whose ties to London stretch back to the Empire and beyond. The largest bulge-bracket financial service companies bring together all four markets (and related markets), locating in London to service their diverse client base. Notice, these institutions tend to be organised according to asset categories or classes and related products rather than geographic markets. For example, foreign exchange functions encompass the entire globe on a 24-hour basis rather than being segmented and managed by local offices in countries and regions. Similarly bond trading, equities trading, and private placements of all kinds tend to be functionally centralised according to expertise rather than dispersed according to the specific needs of geographic markets. In part, this kind of functional and product specialization reflects the evolving market for expertise and talent and the increasing flow of assets into London and global markets. Of course, this organisational logic must be sensitive to the tastes and preferences of markets. Function and product teams often combine research with marketing, trading and execution with local regulatory requirements, and product design with client needs. Ideally, combining markets according to product groups enables firms to reap economies of scale on the processing, reporting and execution side of the firm.5 Of course, as noted above, the industry is actually comprised of a handful of self-enclosed bulge-bracket firms and a myriad of small highly specialised firms. Whereas the former aim to reap apparent economies of scale, the latter aim to reap the benefits of agglomeration.6 For smaller firms, close proximity enables specialization, relying upon inter-firm networks rather than the collection under one roof of all necessary and related functions. The combination and growth of markets, the co-existence of rival bulge-bracket firms, and the growth of related small firms have together brought to one place a remarkably diverse labour market and an enormous range of financial services. Inevitably, there is a neat symbiotic relationship between the pool of talent and the provision of financial services. For all financial firms, large and small, London is an invaluable resource as it is a location at the junction of diverse local and global markets.7 PRODUCT DIFFERENTIATION AND QUALITYWe suggested above that product differentiation is a common competitive strategy in oligopolistic industries such as financial services. It was also suggested that financial products and services have a variety of elements or components including, for example, (1) an asset designation, (2) a market designation, (3) a measure of relative performance, (4) a recognised accounts system, (5) a price, and (6) reputation.8 So, to illustrate, a Swiss pension fund might come to London to purchase investment and management expertise for an emerging-markets equity product, comparing competing firms' relative prices, performance and reputations against accepted benchmarks. Price is partly dependent upon the volume of managed assets, there being discounts for larger tranches of assets. However, price is also a function of perceived product and vendor quality. And quality is a combination of all six attributes or components of the product. Not surprisingly, firms compete with one another on the basis of perceived product quality while seeking to differentiate their products from others' rival products. Why come to London to purchase an emerging-markets equities product?9 There are at least three plausible answers. In the first instance, London has been the dominant European centre providing such products reflecting an historical legacy as much as current competence. In this respect, a firm's reputation may depend upon the reputation of its financial centre as much as its own competence. In the second instance, there is a choice of potential vendors in the London market whereas in the local (Zurich) market there maybe only one or two vendors. Therefore, it may pay the producers of such products to co-locate with other producers of similar financial products and services recognising that the purchasers of such products directly compare and evaluate potential vendors. This is a version of Hotelling's (1929) theory of locational choice. In this case, the formality of investment decision-making on the demand side of the equation may require a similar level of formality on the production side of the equation. In the third instance, London may be better able to provide related financial services including third party advice about the respective virtues of competing vendors. Inevitably, just as firms have strong incentives to differentiate themselves they also have strong incentives to co-locate with one-another. We must be careful, however, not to suggest or imply that there is only one global location from which to supply financial products and services to each and every market. In fact, there are many financial centers around the world providing a variety of similar and some times dissimilar products to their local markets. At this point in the argument, I must explain how and why financial centers co-exist with one-another, and why there is a hierarchy of centers differentiated according to the nature of offered financial products and services. In doing so, we need history and geography (in the first instance), and a typology of financial products distinguished according to the nature and sophistication (and therefore quality) of the product (in the second instance; see also Clark and O'Connor 1997). History and geography provides a simple but compelling story. Countries of the world can be sifted and sorted into a set of financial systems characterised by very different legal and regulatory regimes (see especially La Porta et al. 1998). These systems carry with them markedly different historical legacies, reflecting the accumulated effects of economic and political forces at work in these countries over the past 200 to 300 years (Roe 1994). This topic is, of course, the subject of detailed and extensive historical study. In terms of contemporary political economy, the role and status of these different systems is expressed through debate about the proper regulation of corporate governance, the role of financial markets, and the inherited responsibilities of institutions such as banks. See, for example, the compendium edited by Hopt et al. (1998), the recent analysis of the German and US systems of corporate governance by O'Sullivan (2000), and the assessment by Ronald Dore (2000) of the conflict between rival systems and the possible costs of resolution of conflict through the increasing dominance of the Anglo-American system of corporate governance. Whereas London collects in one place a variety of markets, it also collects together expertise relevant to very different regulatory requirements. Three implications immediately follow from this point. First, some regulatory regimes internalise and isolate to privileged financial institutions the production and consumption of financial products and services. By contrast, some regulatory regimes encourage (and sometimes require) the provision of financial products and services through third party agents located in financial markets. Second, some regulatory regimes impose detailed and restrictive covenants on the consumption of financial products and services, effectively ruling-out whole groups of financial products or at least limiting the consumption of such products while deliberately favouring other kinds of products. Third, to the extent that regulatory systems allow or enable the common consumption of certain types of financial products and services these systems may nevertheless impose restrictions upon cross-border financial flows effectively balkanising local markets. The classic comparison to be made is, of course, between the equity and market culture of the Anglo-American world and the banking and bond culture of the Germanic world. Recent European Union initiatives designed to facilitate the development of a single market for financial services tackle the second and third implications noted above (Clark 2002b). Taking this point further, consider also the following observations. It seems inevitable that some financial products will never make it to the London market because they are not "products" rather un-traded commercial relationships. At issue, in this context, is the extent to which un-traded relationships may be discounted in favour of market as opposed to institutional intermediation (Boot and Thakor 1997). Some products are so distinctive, reflecting history and geography (path dependence), that they are only reasonably produced at the local level not at the global level. Some "common" products may nevertheless require local management and production because of exacting local reporting requirements that dominate some markets as opposed to global markets. And some products produced in London draw European and global consumers because they are either not offered locally or if offered locally are done so on the basis of limited experience and expertise. In combination, this accounts for the co-existence of markets and the fact that London and New York offer a broad range of "global" products and services as well as "local" products offered for London and European consumers. But if we are not careful, this logic runs the risk of being overly deterministic: as the past provides an account of differentiation, when pushed into the future to "explain" persistent difference it may ignore contingency. In fact, we also must be sensitive to forces driving the spatial concentration of the financial services industry. This is especially important when considering London in relation to Europe. Furthermore the issue of spatial concentration can be seen as reflection of concomitant forces of competitive change like increasing concentration in national and international financial industries. Berger et al. (1999) provides a comprehensive survey of the causes and consequences of consolidation in the US, European and international financial service industries. In doing so, they note that the US financial services industry has been comparatively un-concentrated for many years, reflecting no doubt the long-term importance of state-level banking regulations and the barriers imposed on cross-sector consolidation by the Glass-Steagall Act. This topic is widely researched, and as yet unresolved. Here, my argument concerns the interaction between spatial and industrial consolidation as regards the demand for product type and quality. I would argue that the importance of London in the European financial services industry is the result of increasing demand by continental European institutional consumers for financial products based in the London market and often, but not exclusively, provided by the bulge-bracket financial corporations. This suggests there is something special about London as there is something special about the bulge-bracket financial corporations. In summary terms, I would suggest that London provides regulatory systems consistent with the provision of sophisticated financial products, just as the bulge-bracket firms are able to provide management and reporting systems that meet high standards of accountability and the need of many continental institutions for greater transparency in the management process. This does not mean that systems of regulation, accountability, and trasparency are in any sense perfect; rather it is better understood that these systems are superior to continental systems, and are more sensitive to the evolving nature of financial products and services. It is an issue of relative not absolute quality. To illustrate, let us return to our Swiss pension fund. We have already noted that neither the Zurich market nor for that matter the Frankfurt or Paris markets may be able to provide an adequate choice of vendors and products. Emerging-market equity products combine complicated currency hedging with detailed research on far-flung markets in non-European regions of the world. As well, UK regulators have extensive experience in overseeing the flow of such transactions and a mode of regulation quite different from their continental colleagues. This is, perhaps, most easily summarised in a distinction between (UK) procedural as opposed to (continental) substantive regulation based upon inherited and statutory conceptions of fiduciary duty (see also Langbein 1997). Furthermore, until very recently continental regulators being centred-upon banking and insurance have tended to view hedging and derivative products with great unease. Indeed, continental regulatory systems have imposed strict requirements and closely scrutinised the use and allocation of assets to such products. Of course, going to London does not mean that continental institutions evade local regulators. But it does mean that London-based vendors may have far greater experience with the complex nature and regulation of these products compared to their continental-based competitors (unless they also locate those functions in London -- which is increasingly the case witness the location decisions of German, Swiss, and French companies). There is a further important aspect of the argument. Our pension fund, having relied for many years upon local institutions for financial services, may find in London financial institutions more able and willing to provide greater accountability and transparency in the design and execution of their financial services. By breaking away from the close, even personal, relationships that have dominated the Zurich financial centre, our pension fund may be able to redefine desired product quality in relation to local service providers while learning more about the quality of related financial services in international markets. In effect, as London is a market for financial services, it is desired as such by European institutions dominated by long-established relationships. London allows continental European institutions to impose discipline upon their existing networks of product and service providers in their home jurisdictions. Product quality is, consequently, a means by which the relationships between buyers and sellers of financial products may be governed if not formally regulated. Inevitably, the imposition of market price and quality provides a strong weapon driving the observed dis-intermediation of European financial industries. The unresolved issue, however, for our pension fund is whether London could or should supplant its long-term local product vendors. COMPLEMENTARITIES AND CONCENTRATIONSo far, we have treated the demand and supply of financial products as a discreet process. Consumers and producers are assumed to enter and leave markets according to product needs and specifications. This has provided a logic whereby the London market dominates European markets by virtue of the combination of separate products offered therein. However, in this section I want to complicate the analysis by suggesting that there are significant complementarities between financial products and services. When our Swiss pension fund purchases an emerging-markets equity product they also purchase a variety of complementary financial services either from the immediate provider of the emerging markets product or by providers that can provide services consistent with that type of product. This argument involves at least two related issues: in the first instance, the nature and scope of complementarity and, in the second instance, the organizational structures that can provide identified complementarities. In developing this analysis, I rely upon conventional definitions of costs and Richardson's (1990) seminal treatment complementarities.10 Let us assume there are three types of costs in the production process. Variable costs increase with the volume of output, and as output increases, variable costs increase at a lower rate (increasing returns to scale). Fixed costs exist whatever the volume of output. And if output were to cease, fixed costs would be negligible. As output increases, however, producers are able to spread fixed costs across more and more units of output thereby decreasing per-unit costs. There are also sunk costs. For simplicity, there are sunk costs at the point of entry into a market and at the point of exit from a market. By definition, sunk costs cannot be recovered. All these costs are the weapons of competitive strategy just as they are burdens upon competitive strategy. To illustrate, as the flow of assets increases more and more people are needed (at a decreasing rate) to manage those assets. Firms must also provide regardless of the level of output certain accounting and fiduciary functions that consistently trace the flow of assets in the production process. And firms must have certain capital and technological infrastructures if they are to enter a market and if they are to repel potential competitors (see Armstrong et al. 1994 on the interaction between costs and strategy). Richardson identified a variety of complementarities in the production process. He suggested that "(m)any of the operations taken within one firm are obviously complementary; it is recognised that the cost of obtaining additional output will be less if the level of several operations can be varied and not merely that of one of them" (p. 73). Resources may be switched within the firm to adjust the level of output without changing the overall firm-based level of inputs (TYPE 1). He also noted a second type of complementarity -- the result of the unplanned actions of external consumers of inputs. A group of firms may purchase the same inputs thereby increasing returns to scale of the external provider and contributing to the lower costs of production by the purchasers of that product or products (TYPE 2). He also suggested that there might be a close association between the demand for one good, and the demand for other goods (even if he believed this is unusual in advanced economies) (TYPE 3). Finally, he notes "a further kind of complementarity by which almost all investments are related" (page 74). Even if there are no close relationships between firms, the multiplier effects of purchasing and producing goods and services will produce income and employment spread throughout the entire economy adding to the overall flow of demand and supply (assuming the economy is geographically bounded and integrated) (TYPE 4). I would contend that each and every TYPE of complementarity is present in the global financial services industry, and their existence drives the shared agglomeration or external economies of London as a site of production (relative to its competitors).11 However, none of these TYPES of complementarities need reside within a firm; they may be present and shared between firms so that each and every firm could be very small and highly specialised. We have also to account for the co-existence of the bulge-bracket firms with the boutique firms if the analysis is to be entirely relevant to the circumstances of the financial services industry. To illustrate, let us again return to our Swiss pension fund seeking an emerging-markets equity product.12 In the first instance, the fund will rely upon the expertise of an asset consultant in choosing the product provider. The consultant could be a global consultant, with a branch office in Zurich. Alternatively, the consultant may be "local" with close London connections. In this way, the client is passed through the consultant into the London market. Assuming a product provider is chosen offering a highly reputable product, it may do so at a low cost by switching resources from within the firm or by sharing the mandate with another, closely related firm. The winning combination of reputation and low-cost is made possible by complementarity within and/or between firms (TYPE 1). As well, the firm may be able to offer cost-efficient execution of the product utilising shared market-clearing electronic infrastructure (TYPE 2). Once the product is "purchased", a set of related services must also be purchased to transfer assets to and from London. Currency hedging, custodial services, and compliance services are all necessary (TYPE 3). These complementary services may be provided within the firm or on contract from outside the firm. Finally, added together, the purchase of emerging-markets equity products by European institutions relies upon competence in London, thereby drawing-in talented employees and yet more customers to London (TYPE 4). Basically, TYPE 1 complementarity discounts both variable and fixed costs and may do so such that the added mandate is of no added cost (or just a marginal additional cost) to the providing firm. With regard to TYPE 2 complementarity, shared market infrastructure maybe of double benefit to the providing firm being neither a fixed cost nor for that matter a sunk cost. Indeed, financial services firms may choose London precisely because the infrastructure costs of market execution are already provided and any liability for future costs are borne by third party institutions. However, the fact that an emerging-markets product is actually a product comprised of a set of closely associated products means that the product provider maybe able to offer those services from the same set of services offered to other consumers of related products (TYPE 3). It may be able to offer a bundle of associated products at competitive prices relying upon the existing complementaries within the firm or between the firm and its partners (TYPE 1). Of course, if the customer requires some special associated product or service (perhaps related to local regulatory requirements), the diversity and scope of London is such that the product provider can act as a third party broker sharing its mandate with a firm providing the needed speciality services (TYPE 4). It would be misleading to imply or suggest that complementarities are so easily resolved in favour of the firm and the customer. For providers, realising the cost advantages of complementarities is an issue of organisation (the nature and scope of the firm) and an issue of management (the implementation of desired goals).13 Both are topics of enormous complexity and significance for the theory and practice of corporate governance. Indeed, as noted above, they reflect a continuing debate about the relative performance of whole systems of national corporate structure and finance. So, for example, whereas Anglo-American systems combine firms with markets for financial products and services, the German and Japanese systems have tended to internalise the provision of financial products and services within long-term relationships between overlapping institutions (Allen and Gale 2000). Given global and European financial and capital market integration, the relative performance of rather different mechanisms of organisation and management has come into play. Indeed, the move of our Swiss pension fund to London for an emerging-markets product could be interpreted as a move between national systems for financial advantage. Here, there are two crucial issues. First, the growth of bulge-bracket financial firms and, second, their functional and spatial concentration in the London real estate market. Like Coase (1988), Richardson (1990, p. 73) contended that the boundaries of an individual firm are "in any case, to some extent arbitrary." This initial point of departure provided Richardson with a rationale for identifying and accounting for the existence of functional complementarities whatever the boundaries of firms. In recent years however, it could be argued that the financial industry has decided that TYPE 1 and 3 complementarities can be best achieved by increasing the size and scope of firms. This does not mean that the only successful firm need be a large or super-large firm. There is widespread debate about the costs and benefits of mergers and acquisitions in the finance industry (Berger et al. 1999). And it is not clear that the strong incentives for senior managers in orchestrating such mergers are realised in the flow of income or in cost savings as represented by extra profits for shareholders. Partnerships and other forms of corporate structure remain important amongst smaller firms in the Anglo-American finance industry. As firms have grown larger, as they have brought together complementary functions and products, and as they have sought to integrate marketing and client relationships across related products and markets, they have sought modes of organisation that allow and even enhance internal flexibility. One expression of this process of internal co-ordination and consolidation has been the development of product groups like global fixed income, global equities, advanced derivative products, debt markets and products etc. Here, the organisational logic has been the integration of overlapping areas and functions across markets and around the world rather than the continued segmentation of products and markets around star-led personal fiefdoms. Indeed, a related element in this organisational structure has been the creation of hierarchies and management structures aimed at greater internal accountability whatever the location or product. So, for example, the head of global equities may be located in London, drawing together teams of employees based on related products and services from around the world internal to the firm. The management process is daily, weekly, and monthly, and the spatial scope global. This kind of integration has allowed the largest firms the opportunity to discount personality in favour of proclaimed management competence.14 It is also apparent that the internalisation of complementarities has prompted spatial consolidation. Whereas the old City of London was characterised by networks of similarly located smaller firms, the new model of firm organisation and management is one based upon huge office towers of many thousands of employees. Canary Wharf is a remarkable expression of the search for management solutions to the problem of functional integration. It is not uncommon, amongst the bulge-bracket firms, to bring together on one site 8,000 or 10,000 employees co-locating not for inter-firm face-to-face synergies (the mantra of the City of London model) but for intra-firm management coherence. In this world, it appears that neither the City of London nor other European markets have the real estate and related infrastructure necessary to sustain such large units of production. In a tangible way, the one-site economies of scale associated with fordist assembly-line manufacturing plants have been replicated in the enormous buildings of financial institutions. This is an Anglo-American phenomenon, increasingly mimicked by foreign investment groups locating in London whether French, German or Japanese. LONDON IN EUROPE AND BEYONDThe analysis in previous sections brought together a variety of forces that have contributed to the growth of London in the global economy. By structuring the argument in this way, we have constructed piece-by-piece an economic and geographical logic that explains London's dominance of European financial industries. But the analysis is selective: we take from history those forces that have made the success of London seemingly inevitable. For example, on the issue of market size, the history of London as the centre of Empire and trade for more than two centuries suggests that this is an important variable for some, perhaps the most compelling variable (see Bindemann 1999). Likewise, the particular nature of Anglo-American financial regulatory regimes combined with the beneficial consequences of market liberalisation in the 1980s can be invoked to "explain" the contemporary dominance of London over continental European traditions. In effect, path dependence provides the rationale for scale economies and the nature of financial products provides the rationale for agglomeration economies. When these elements are combined with industry competition and corporate strategy, London seems to be the natural place to locate. However, I am uneasy about this logic on a couple of counts. Embedded is a very strong argument about history and geography. Implied is an argument of necessity: that history and geography together drive processes of industry competition and corporate strategy. This is a form of structural determinism wherein the agency of firms and competitors depends upon these determining background conditions. Whether this is true or not is actually an empirical question rather than an unassailable fact of life. For example, the large bulge-bracket financial institutions that dominate London have come to London in a very deliberate fashion. Given their financial resources, they have the capacity to choose other locations. For them, history and geography are strategic variables rather than pre-ordained circumstances to which they can only respond. Furthermore, given the enormous flows of revenue through these companies they have significant mobility potential--any investment in a London location could be easily discounted against the flow of future revenue. Sunk costs are rarely a constraint on restructuring; compared to manufacturing enterprises, capital and infrastructure investments are far less significant than the costs of labour (Clark 2000). The past is not necessarily the future. To illustrate, consider the following four disadvantages of London compared to Frankfurt and Paris. Transport networks: grid-lock dominates the everyday life of finance industry executives and their employees. London airports are overwhelmed with traffic, the radial road network linking Heathrow in the west with Canary Wharf in the east comes to a standstill during peak hours, and the underground rail system is archaic and subject to widespread disruption. Canary Wharf: not withstanding its importance for the bulge-bracket financial institutions, its location on the eastern border of the commercial heart of London makes it a most isolated location relative to the residential preferences of employees and domestic corporate headquarters. In fact, accessibility to local finance markets and institutions is not obviously that much better than accessibility to European and international finance markets. Labour markets: over the past decade, the UK economy has grown rapidly and employment rates have surged (particularly in the south-east of England). Full employment characterises the southeast, driving wages and salaries even at the bottom end of skill and occupation. More significantly, inter-firm rivalry for the most able finance executives makes London a very expensive location. Capital markets: the available evidence suggests that European capital markets are more cost-efficient than the London markets. Furthermore, the electronic infrastructures of European markets are far more advanced and accessible to securities traders from around the world. All four issues directly or indirectly affect the costs of producing financial products and services in London relative to Frankfurt and Paris. Whereas we have emphasised the benefits of agglomeration and scale economies accruing to firms located in London, we could also emphasise the costs of agglomeration and the dis-economies of scale. Likewise, we could also emphasise the potential significance of electronic transaction and trading systems for the decentralisation of the global finance industry. Many products, especially equity and bond products, are easily sold and executed from remote locations or at least other European locations (witness Luxembourg). Distributed electronic networks could replace many of the centralised London-based functions of global financial institutions. Indeed, the development of advanced electronic trading platforms in Frankfurt and Paris has been driven, in part, by very strong Franco-German economic and political interests aimed at discounting the influence of the London and New York financial markets. The advantages of history and geography may be limited to a certain point in time and space.15 Therefore, we should assume that the benefits of a London location (in situ scale economies and complementarities) are contingent rather than set in bricks and mortar forever. Even so, I want to suggest that London's capital switching functions will remain important for European financial and pension institutions and may even increase in importance overtime. This is most obvious, at present, in relation to the flow of capital from Europe to the rest of the world (especially the US) and is reflected in the short-term trade in currencies, hedging and derivatives. Much has been written about the interaction between capital flows, currency exchange rates and speculation. It is sufficient to observe that the arbitrage process is an industry in its own right (Clark 2000). Perhaps less obviously London's switching functions are also vital for those institutions concerned to place European assets in long-term non-European investments thereby seeking higher rates of return than that which can be achieved in European economies and markets. In doing so, one goal is to "cover" long-term European pension liabilities with diversified portfolios of industries, regions and demographies. By relying upon low rates of cross-correlation between international sector-region-demography combinations, it is hoped that European institutions will reap stable but higher rates of return so as to make-up the difference in slow rates of European economic growth. Dutch pension fund institutions have clearly taken advantage of these opportunities (Clark and Bennett 2001). At the same time, this issue is also important for other larger economies such as France and Germany (Clark 2002a, 2000b). I would argue that for European institutions seeking to use market mechanisms to spread demographic and funding risks and to more effectively invest and manage pension assets and liabilities, the London market has two basic virtues. In the first instance, the London market brings together in one place great diversity of market participants and, consequently, great diversity of risk preferences and profiles. The combination of diverse risk profiles and the depth of liquidity apparent in the London market is remarkable (but not without significant competition). Even in the most severe of crises like the recent Asian meltdown (1997), the shocks occasioned by Latin American threats of default, the aftermath of the TMT bubble, and the World Trade Center tragedy the London market has remained deep-enough to accommodate those wishing to buy and those wishing to sell country-specific risks. Being at the centre of capital switching between Asia, Europe and North America, London remains an essential point of reference in the global economy. Inevitably, as global financial regulatory regimes have sought to smooth inter-jurisdictional barriers to capital flow, these initiatives have London as a crucial reference point. In this respect, whereas electronic communication networks represent a threat to London, the same networks may simply ease the flow of capital and transactions into and out of London (or a place just like London with its particular location in time and space). Market diversity and liquidity could be "electronic" and geographically distributed rather than concentrated in London. However, an essential "localising" factor is the talent pool of the London financial industry--something that dominates European markets. This is a complex issue, as we have seen partly driven by the range of financial products and services produced in London as well as the complementarities that draw together needed diverse sets of skills and expertise. But notice how important the existing talent pool may be in the future: product innovation, the design and execution of products consistent with a wide variety of market players, and the ability to capitalise on complementarities and scale economies all demand highly talented individuals. In this respect, as London has become a vital resource for firms it is also an important income and employment opportunity for talented workers. By contrast, Frankfurt and Paris are not nearly as attractive for talented labour concerned to maximise income and long-term wealth. Whereas the bulge-bracket financial institutions are alarmed at the cost implications of tournaments for labour, their response has been to increase capital investment and the automation of routine low-skilled functions. It is plausible that these same institutions will use advanced electronic communications to decentralise to Europe the production of routine services. Even so, the competitiveness of financial centres is based less on the costs of routine production and more on the attraction and retention of talent (as in other knowledge-intensive industries; see Florida 2001 and Teece 2000). The collection of financial capital, the pooling and distribution of risk, and the management of investment are basic functions of any capital market. Historically, in many European countries these functions have been provided internally to partners in overlapping and commonly shared untraded relationships. As we have seen, these relationships are often highly localised and regionalised with the risks of such relationships also highly localised; witness the research on German capital markets by Wojcik (2001). If London is to be geographically spread through Europe, its capital switching and risk pooling functions must be bundled in hyperspace rather than geographical space. The challenge is to build a system of markets that can sustain these functions while avoiding the concentration of risks and the diminution of liquidity and talent inherent in local markets. CONCLUSIONSMany studies of the recent history of the City of London document its transformation from a club-like industrial district to a massive conglomeration of one-stop financial "supermarkets" providing diverse products and services. In doing so, studies such as David Kynaston's (2001) latest instalment bring together the crisis of the early 1980s and the big-bang of financial deregulation in 1986 with the demise of indigenous financial institutions. Mergers and acquisitions by US and other international financial groups have profoundly altered the London financial industry. Being no longer just the City, being the whole region and beyond it is an essential site of production in the international finance industry. For some, there is genuine regret for the passing of an era. The networks of personal contacts, the emphasis upon custom and convention, and the neighbourly interchange of personalities and institutions has given way to the routine compensation and employment practices of bulge-bracket financial corporations.16 In some quarters, but by no means in David Kynaston's book, there is lament for the demise of the City as a national icon. The take-over of City institutions has been interpreted as a rejection of national institutions and their leaders. Thus, the rise of London out of the old City can be traced back to the apparent complacency and amateur status of many old City institutions. The City has been replaced by an industry whose "identity" is self-consciously cosmopolitan, corporate and international. Indeed, London's attractiveness for talent compared to Frankfurt and Paris is precisely its relative openness and cosmopolitan nature. By contrast, being a British institution the City employed Londoners from the east-end and west-end of the city-region but sought to exclude those who did not "fit-in". My argument in this paper is that understanding London in the world of finance requires understanding it as an industry, and all that implies in terms of products and services. In doing so, we have relied heavily on two sets of arguments one having to do with the nature of markets served by London and the other having to do with the complementarities inherent in the provision of financial products and services. On the markets side of the equation, I have argued that scale economies combined with a distinctive regulatory heritage has provided London significant advantages as a central location for the provision of financial analysis services in Europe and around the world. This analysis will be familiar to those economic geographers schooled in Hotelling-type models of location as well as those familiar with notions of product range and threshold (see for example Berry 1967). As for complementarities, the analysis also provides a production-oriented view of the overlapping and related nature of financial products. Once we recognise the nature and scope of complementarities, we must also recognise the unique interaction between markets and the scope of products produced in London. This much is recognised by the bulge-bracket financial firms that have chosen London as a centre of production. So significant has been this choice of location that the conglomeration of these firms and the centralisation of functions within vast buildings have re-created in concrete an image of the past: factories for the production of financial services and products. It could be argued, moreover, that whatever the economies of scale and the agglomeration effects of complementarity, London is a necessary feature of the global economy. The global economy requires a centre that brings together diverse risk profiles just as the global economy requires a switching point between Asia, and Europe and North America. In this respect, London is a vital point in time and space for the global financial institutions that manage on a 24-hour basis flows of capital and transactions around the world. Put slightly differently, if London did not exist its place (in time and space) would have to be invented by the bulge-bracket financial service firms concerned with managing the global risk profiles of their customers and their own accounts. It is no accident that London sits virtually on top of Greenwich mean-time, the central reference point for calibrating time and space according to a common and accepted metric around the globe.17 For financial houses, London's place in time provides them a virtually unique place from which to actively integrate and strategically manage their daily trading-books from (in the east) Tokyo to San Francisco (in the west) on any day. Frankfurt and Paris could provide the same geographical function. But they could not match London's market diversity and liquidity or London's depth of talent. One remarkable aspect of the contemporary debate about London in relation to Europe is the sense in which the national anxieties that accompanied the demise of the old City are being replayed in the leading financial and political centres of Europe. Attempts to develop and protect national financial institutions as competitors with the Anglo-Americans reflect similar UK attitudes of the 1980s. Attempts to fashion EU rules and regulations that can accommodate the competence of Anglo-American financial groups with continental European banking and insurance houses seems similarly to be ways of shoring-up those houses against the competition. Whether these attempts will be any more successful than UK last-ditch efforts at maintaining the national identity of finance seems doubtful. At the same time, the success of London as an international centre is a profound threat to the international ambitions of Frankfurt and Paris. Indeed, Frankfurt and Paris may be vital cogs in the wheel for mobilising pension assets and liabilities for trade and transaction through London. By this logic, London never replaces Frankfurt and Paris but uses those centres to organise the continental flow of funds into the world. ACKNOWLEDGEMENTThis paper was made possible by the support of AIG Financial Products Corp., a grant from the Future Governance programme of the UK Economic and Social Research Council, and a 4th Framework programme grant from the European Union. Respectively, I would like to thank Joe Cassano and Robert Hirst, Edward Page and Adam Tickell, and William Lazonick and Mary O'Sullivan for their personal and financial support. I would also like to thank Duncan McKenzie (IFSL) for his help in identifying relevant data, Nigel Thrift (Bristol) for his sense of time, and Simon Ford and Giles Keating of CSFB for their shared insights. I should acknowledge Linda Atkinson's bibliographic skills and Jane Battersby's editorial help. Jan Burke processed and reprocessed the manuscript. None of the above should be held responsible for any errors or omissions. REFERENCESAllen, F. and D. Gale. 2000. Comparing Financial Systems. Cambridge MA: MIT Press Amin, A. and N. Thrift. 1992. Neo-Marshallian nodes in global networks. International Journal of Urban and Regional Research 16, 571-587 Armstrong, M., S. Cowan and J. Vickers. 1994. Regulatory Reform: Economic Analysis and British Experience. Cambridge MA: MIT Press Arthur, W B. 1992. Increasing Returns and Path Dependence in the Economy. Ann Arbor: University of Michigan Press Bagehot, W. [1873] 1999. Lombard Street: A Description of the Money Market. 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Clark, School of Geography and the Environment, and the Said Business School, University of Oxford, Mansfield Rd., Oxford OX1 3TB, United Kingdom. E-mail: gordon.clark@geog.ox.ac.uk 1. This paper was written over the summer of 2001, and finished in October 2001. Along the way, the human tragedy apparent in the attack on the World Trade Center in New York caused me to reflect long and hard on the symbolic character of finance capital. Here, after a great deal of soul-searching, I decide to leave New York out of the argument. Even so, speculation abounds about the long-term effects of the attack for New York in relation to London (and vice versa). Martin Dickson in the Financial Times (23rd September, 2001, 17) usefully summarised my opinion, suggesting that London is "now a hub and its own right and should escape the worst. Many of its high value-added functions can only be done with a presence on the ground. And the attack on the World Trade Center has cruelly underscored that there are benefits to geographical diversification." Further, I also agree with his argument that "Europe is where the action is, and London is where that business is done" (quoting Roberts and Kynaston 2001, page 14). Indeed, this is the subject of the paper. 2. This paper is the result of over a hundred in-depth interviews conducted with UK and European pension and retirement income sponsors, corporations, and financial institutions. Details about who has been interviewed, the spread of interviews between countries, and the time frame over which the project has proceeded can be obtained from the author. Much has been written about "close dialogue" as a form of research methodology; see, for example, Clark (1998) (in geography) and Helper (2000) (in economics). At this point, it would seem less important to re-run the debate about the cost and benefits of this research approach given that it is treated so extensively in the relevant journals. 3. Important historical treatments of the topic include the following. Braudel's (1992) assessment of the role and significance of city-states and global finance is very instructive, as is Ferguson's (2001) broad assessment of the interaction between politics and money. The most important source on the City of London is, of course, David Kynaston's multi-volume historical study. The most recent instalment concerns the City of London over the period 1970-2000 (Kynaston 2001). There are many other relevant sources. 4. Recent work on financial centres and the global economy include Houthakker and Williamson (1996) (on economic treatment of the theory and structure of financial markets including reference to "central trading places") and Warf (2000) (a geographical analysis of the role of the status of Wall Street and New York). Leyshon and Thrift (1997) provide a broad-ranging assessment of the topics relating to the emerging field of financial geography. 5. See the argument of Richardson (1990, 89-90) to the effect that economies of scale are a function of the size of market, and the rate of growth of market. He also suggests that economies of scale are factored into short-term decision-making more than long-term decision-making because the latter requires an assessment of, and provision for, the durability of capital as well as the volume of expected output. 6. Very simply, agglomeration economies can be seen as those benefits that accrue to firms located in the same jurisdiction. In part, they can co-joint location to "exchange information by face-to-face communications and reduce various kinds of transaction costs between firms" (Tabuchi 1998, 333). 7. This paper could be seen to be yet another attack upon the "end of geography" thesis. And so it is. We should also recognise that the stickiness of time and space has become a vital ingredient in theorizing the management of institutions as well as theorizing macro-economic integration and stability. See Diamond (1994) for an especially intriguing combination of economics and geography relevant to these issues. Note, however, that there remains a residual belief that stock markets are different than neighbourhood commodity markets. 8. There is surprisingly little academic research on the determinants of the prices of financial products. Much of the research takes as given the production process and is concerned with the price efficiency (or otherwise) of financial markets. See, for example, Houthakker and Williamson (1996). Here, I merely assert that the price of a financial product is so determined (based upon my industry interviews). 9. Here, I emphasise the issue of emerging-markets equity products because they are so significant for many UK and European pension institutions as a means of spreading investments into the global economy outside of the United States. This does not mean that the proportion of assets allocated to such investments need be a large compared to the apparent "home bias" and "asset bias" (which varies also by countries) of these institutions. See, for example, treatment of these issues in Davis (1995) and Clark (2000). 10. While I use the term "complimentary" to describe the overlaps or interdependence between products and services, I could have invoked the concept of "scope". Perhaps this is more conventional; see Viscusi et al. (1995, ch. 11) for more details including reference to original treatments of economies of scope. Even so, Richardson's treatment is more extensive and intriguing. 11. Important complementary financial services include legal services of all kinds. There is considerable evidence supporting the proposition that US law firms specialising in securities, mergers and acquisitions, and the market for corporate control in general have come to London to take advantage of its place in relation to Europe. At the same time, UK law firms have become global linking-up Europe through London to the United States and beyond. The most significant recent project devoted to the globalisation of legal services (bearing upon the finance industry) is that of Beaverstock, Taylor and Smith (1999) and Beaverstock, Smith and Taylor (2000). 12. It is also important to acknowledge that emerging-markets equity products are very sensitive indeed to the expertise of active investment managers, the flow of information and its qualitative assessment. As is well appreciated in the industry, these types of products remain the terrain of knowledgeable experts even if passive index products are increasingly dominant in the UK and US investment management community. On the consequences of information for the expertise needed to manage investment products across the world see Clark and O'Connor (1997). 13. For consumers, the existence of complementarities between products may simultaneously offer costs-saving synergies and impede the switching of consumption between rival providers. On the consequences of significant switching costs for corporate strategy and price competition see the seminal contribution by Klemperer (1987). At the limit, complementarities combined with significant switching costs may "trap" consumers within multi-functional firms - the proclaimed difference between financial systems based on markets and those based upon intermediaries may evaporate into common-function but "different" institutions. 14. In this paper, I have not been able to deal in any detail with the location of London in relation to the formal structure of time and space. One industry respondent has emphasised that London is a vital to global finance precisely because of its relative place in the 24 hour trading cycles of large multi-jurisdictional financial institutions. Being able to talk directly with Tokyo and then talk with Wall Street seems to be a most important means of sustaining integration and management within firms and their product groups. 15. See for more details, the study by Schulte and Violi (2001) on the rapidly changing nature and structure of European Euro-bond futures markets. Whereas just four years ago the London LIFFE market and the EUREX market shared such trading between them, by 2002 EUREX dominated LIFFE. While a specific instance, rather than a comprehensive pattern across all related products it is an indication of the powerful forces driving market rivalries and the interest in market consolidation across Europe. 16. The imposition of management systems on "local" financial firms in London through mergers and acquisitions (and other imperatives) resonates with history. See, for example, Chandler (1977, pp. 415-416) on the early twentieth-century managerial revolution in US manufacturing enterprises. Therein he notes that mergers between firms prompted "top managers" to institute systematic and "uniform accounting and statistical controls. In hiring and allocating managerial personnel they began to think more systematically about evaluating managerial performance." The recent history of bulge-bracket firms in the finance industry could be so written. 17. There have been a number of studies published on the creation of Standard Time, drawing together the imperatives of the industrial revolution and its rail transport systems with the need to make systematic according to a common metric the often arbitrary but minor differences in time between places (running east to west). For a US perspective on this issue, emphasising the role of the railways see Bartky (2000). For a Canadian perspective, referencing an individual and international political economy (among its many other issues) see Blaise (2000). And for a more scholarly and interpretive perspective linking Einstein with almost everything else see Galison (2000).
Edited and posted on the web on 25th October 2001 Note: This Research Bulletin has been published in Journal of Economic Geography, 2 (4), (2002), 433-453 |
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