Over-regulation or under-compliance? What is really behind London’s decline as the financial centre of the world?

February 6, 2013

This article was originally written for and featured in Business Money.

In the middle of the ongoing debate surrounding financial regulation, the Centre for Economics and Business Research has stoked the fire by announcing that London has been ousted as the financial hub of the world. According to CEBR’s research, the number of financial services jobs in London has fallen behind New York and, by 2015, it will slump into third place behind Hong Kong.

Many commentators have suggested that over-regulation is the sole contributor to this state of affairs. There is no doubt that since the financial crisis first struck, financial regulation in the UK has witnessed an unprecedented amount of reform, and among the most significant changes are the Basel III rules on capital adequacy and liquidity, created in response to the crisis.

The implications for UK financial institutions of implementing the Basel III requirements cannot be underestimated, as they represent the most challenging regulatory change that the banking industry has ever seen. In essence, the complex and cumbersome rules require financial institutions to increase the size of their capital reserves, as well as meet new regulatory requirements on bank liquidity and leverage.

The additional requirements are intended to decrease interdependence between financial institutions and effectively reduce the risk of a future financial crisis. Financial institutions were under pressure to prove that they could meet them by 1 January this year, although the rules are not due to be fully phased in until 2019. Some of those institutions already showed signs of struggling to generate the required capital in the current economic climate and were being encouraged by the Bank of England to consider seeking alternative sources of capital, including equity, in order to meet the stringent requirements.

Together with the more exacting rules, financial institutions in the City faced significant operational and financial challenges in ring-fencing their retail arms from investment activities. Institutions also faced uncertainty over their regulatory supervision, as the reorganisation of the FSA started to come into effect and new powers were introduced.

This year, the Prudential Regulatory Authority will be responsible for the regulation of banks and insurance companies and the Financial Conduct Authority will be responsible for the regulation of market practice and consumer protection. The Bank of England’s Financial Policy Committee will have overall responsibility for financial stability. The FCA will also have more interventionist powers to ban the sale of financial products, in order to prevent harm to consumers, as well as removing financial promotions, or preventing them from being used in the first place, without going through the usual enforcement process.

There has also been a significant increase in focus on the remuneration of bankers since the financial crisis, and a general discontent at the reward culture created by schemes adopted in the City. This led to pressure from the FSA on institutions to introduce checks and limitations on remuneration as highlighted by the FSA’s Remuneration Code, the Retail Distribution Review, as well as the regulator’s thematic review on sales incentive schemes. A continual focus and drive to cut bankers’ bonuses, to avoid a political and media backlash, is also in place.

At the same time, in October 2012, Andrew Bailey, head of the FSA’s prudential business unit, wrote to UK banks warning them that the regulator would be looking for evidence that they had clawed back deferred bonuses from people involved in misconduct. Plus, there is increasing pressure from the EU to introduce caps on the bonuses offered to bankers.

In trying to strike the right balance between light touch risk-based regulation, which many people believe to be the key contributing factor to the global financial crisis, and prescriptive rules and regulations, it appears that the scales may now be tipping too far in favour of the latter, leading to a plethora of burdensome regulations and restrictions which might stifle economic recovery in the City.

Yet, it would be myopic to think that over-regulation is the sole contributor to this shift away from the City. Perhaps the real issue is not that we are now over-regulating the City but, rather, that the City was historically under-compliant. The financial crisis and the recent high-profile scandals, including the manipulation of LIBOR and the UBS rogue trader incident, have very much highlighted the inadequacies in the current financial system and, specifically, the need for institutions to ensure that they have sufficient capital buffers to guard against operational risks, while encouraging a rethink about how staff are incentivised.

Other factors are certainly contributing to the City’s decline as the financial centre of the world. The Bank of England’s systemic risk survey for 2012 highlighted the fact that regulation in the City was not regarded as a primary risk factor to the UK financial system. The risk of another economic downturn was regarded as a more pressing concern by market participants.

Investors have grown sceptical of the City’s financial institutions and their ability to measure risk in the wake of the financial crisis and recent scandals. Undoubtedly, the City has a long way to go towards rebuilding public confidence in the banking system. Increasing regulation, to guard against operational risk, with an increased focus on compliance, might be the only way to effect this.

No one can disagree with the need to introduce regulation and better compliance to deal with these issues. Whether the wave of proposed regulatory reform will ultimately prove effective at predicting and preventing a future financial crisis, or end up being regarded as an ill-conceived, knee-jerk reaction to the current financial crisis, still remains to be seen.

Regardless of where you stand on the issue of regulation and compliance in The City, the key driver behind London’s decline is, we believe, unlikely to be related wholly to this question. There is no escaping the fact that Hong Kong and Singapore too are in the midst of rapid economic expansion. Ultimately, London may in the future have no choice but to take a back seat.


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