LONDON, MONDAY 20 DECEMBER 1999
Howard Davies
Chairman, Financial Services Authority, United Kingdom

In presenting my end of term report to you, I would not wish to imply that I see myself as the City’s headmaster. I don’t think the regulator should be thought of in so grand a light. Perhaps I am a kind of City janitor, cleaning up the occasional mess left by some of the more unruly boys and girls (though disciplinary action in the City against women is astonishingly rare, for reasons not easy to understand).

But whatever the appropriate educational analogue for the Chairman of the FSA might be, I think there is little doubt that we do have a particularly privileged perspective on London’s financial markets, now that all of the key regulatory authorities have been merged into one. For the first time, there is one organisation which can pull together a comprehensive view of the trends in banking, securities, fund management, broking, insurance and all the other aspects of the diverse financial markets that make up the City of London.

So, from that broad perspective, how does this year’s report card look?

I guess the first thing to say is that it has been an exciting twelve months. Beginning with the introduction of the Euro and ending with the Y2K transition - punctuated by an exciting ‘day of action’ half way through.

There is no doubt that the City, collectively, rose brilliantly to the Euro challenge. The Bank’s most recent "practical issues" bulletin set out the details comprehensively, so I will not rehearse them in detail here tonight.

The Bank’s headline conclusion was that "all the available evidence indicates that, since the launch of the Euro, London has fully maintained its market share". Around 18% of all cross border payments sent through the TARGET system go through CHAPS, with only Germany having a higher proportion. London’s market share of the overnight Euro deposit market is around 20%. In foreign exchange, as we forecast beforehand, overall turnover has fallen, but much less in London than elsewhere. Only a small proportion of London’s foreign exchange dealings was between currency pairs within the Eurozone, a much smaller proportion than in London or Frankfurt. And the market share of large firms, most of which are based in London, has increased at the expense of middle sized operators.

In the derivatives sector around 90% of Euro short term interest rate contracts are traded on LIFFE. And in bonds, London’s market share of Euro-denominated eurobonds is estimated at 54%, and appears to be rising.

The Bank’s paper includes an interesting discussion on why London has done so well, and whether it will continue to do so. Two factors seem particularly important. First, many of the major international firms have invested very heavily in building up their presence here. A recent article in the Financial Regulator magazine showed that Goldman Sachs, Merrill Lynch, Chase Manhattan and JP Morgan together employed around 14,500 people in London, and only just over 1,000 people in Frankfurt.

And the second key element is that, if you look at Healey and Baker’s annual survey of Europe’s top cities, London scores very highly on most of the factors particularly relevant to the financial sector, and indeed is perceived by most to be likely to be the future financial capital of Europe over the next five years - a position held by Frankfurt in 1998, before London’s continued ability to attract Euro business became apparent.

Will this last? Who can say. The signs are positive at the moment, but financial institutions are undoubtedly watching the developments of the debate on Europe here very carefully.

They will also, of course, watch carefully how well London shapes up to the challenge financial markets now face in the next couple of weeks - the Millennium date change.

Here, again, the signs look positive. We have been closely monitoring the progress made by firms in adapting their systems over the last twelve months. And we have made public our assessments as firms have progressed through our red, amber and blue traffic light system. Focusing on the firms we rate high and medium impact, there were 13% red and 41% amber in March. They were 100% blue by November. And that covered 1,500 separate businesses.

When we first revealed our assessments - though of course we never named individual firms - there was some concern as to whether we would foment uncertainty and damage confidence. We did not think so, and thought that confidence would, instead, be best maintained if savers and investors thought that there was a regulator with the independence to tell things as they were and to report on progress as it was made. I believe that the fact that we were willing to present an objective and mixed picture earlier in the year has given credibility to our recent assessment that the sector is as ready as it can reasonably be.

Now is not the time to count chickens. But I believe that as much has been done as could reasonably have been done by the City, the FSA and the Bank of England to minimise both the likelihood of problems and the impact of any problems that do occur.

We shall be manning our Millennium Event Office on a 24 hours basis throughout the key period, until 6 January when the first full settlement process has been completed. And we will be in real time contact with regulators in other key financial centres, from Auckland to all points west. We shall have a senior US regulator with us throughout to ensure good transatlantic links.

I hope that the main problem we face at the end of this period is a large bill for take away pizza. But we are ready to handle something worse if it comes along.

So the response to the year’s two challenges looks good, as things stand at present. But what of the underlying business? How robust is the UK’s financial services industry overall, and how competitive internationally? This is a question to which we at the FSA will have to pay greater attention in the future. Our new legislation will require us to take account of the impact of our regulation on the competitive position of the UK’s markets, which we can only do if we have some idea of how competitive they are in the first place.

The full answer to that question cannot, of course, be provided in ten minutes over a dinner table.

If we look at banking, first, we can see that the number of banks active in the City continues to grow, though the big increase is in cross border authorisations from the rest of the EU. There is some slight evidence of concentration and rationalisation in banks from outside Europe, perhaps not surprisingly. The number of Japanese and Korean banks here has, for example, fallen back in the last couple of years.

As for British banks, reported pre-tax profits for the first half of year were up an average of 10% on last year, and were generally ahead of market expectations. Return on equity averaged 30%, almost double the average for the US and three times the rate achieved by major banks in Germany and France. This high profitability might be regarded as something of a mixed blessing, as it has attracted the Treasury’s attention, hence the Cruickshank review of competition in banking. But whatever the outcome of that review we should not forget that a strong, well-capitalised and profitable banking centre is a necessary firm underpinning of healthy financial services in general, and indeed of a robust domestic economy. This is a point well understood in Japan and elsewhere in the Far East, where the need to recapitalise the banking system, after huge losses, continues to hold back the economy as a whole.

There is no doubt, though, that the banking environment here is changing fast. This year has seen rapid growth by some new entrants, notably Prudential’s Internet bank Egg, Standard Life Bank and, more recently, First-E - perhaps the first genuine cross border Internet bank in the European Union. And we should not forget the supermarket banks, which have been growing market share quite strongly too. So the banking sector is both profitable, and lively. You will, I hope, congratulate me on my skill in reviewing UK banking without mentioning the warlike Scots.

Internationally, cross border bank lending originating in London is about 19% of the total global figure, compared with 7% for France and 9% for both Germany and the US. And there is no sign of any falling back in that market share.

Fund management has also been growing strongly. In the last twelve months total retail funds under management in the UK have risen from £179bn to £218bn. Institutional fund management is about ten times as large, at £2.2 trillion, and growing rapidly, up over 20% on the last available twelve month increase. The number of firms authorised to undertake fund management here has gone up by 8% over the last twelve months. In the last year we have authorised 160 new unit trusts and 36 new offshore schemes.

Turning to the equity market, 1999 has been an excellent year, even before the particularly frothy trading in technology related stocks by personal investors which we have been observing just recently. Up to the end of November equity turnover was 34% up on the previous year on the London Stock Exchange and international equity trading up 10%. Gilt trading is down by around 10%, perhaps not surprising given the lack of new issuance in the light of the Government’s strong financial position.

This healthy trading experience is reflected in the number of people authorised to do the business. Once again, authorisations - this time in the old SFA sector - are up by 6% year on year. We have authorised 119 new broking firms in the last twelve months.

Derivatives have done quite well too. The BIS give London’s global market share of OTC derivatives as around 35%, compared with 10% for France and 7% for Germany. Eurex has been the largest derivatives exchange in Europe by volume since it won back the bund contract last year, though bund futures are extensively traded remotely from London. But the notional value of interest rate and equity index contracts is much higher on LIFFE than on both Eurex and in Paris. LIFFE quickly gained 80% market share of the Euribor contract in January and that share has risen to around 90% now.

The insurance sector is a little harder to measure. Lloyd’s have had a difficult year in profit terms, we know, though that is a highly cyclical business and London’s position in marine and aviation insurance globally remains very strong, as does its rôle in reinsurance.

On the life insurance side annual premium business is up 13% and single premium business up 34%. There has been some slight fallback in pensions business, where annual premium contracts are down 4% and single premiums down 1%. But that probably reflects the impact on the market today of the pending introduction of stakeholder pensions and the business overall remains very buoyant.

That is true, as well, of financial advice. The number of authorisations in the old PIA part of our business are also up 6% over the year and the number of individuals registered to give independent financial advice has risen from 22,700 at the end of last year to 26,700 now, an increase of some 18%. Some have predicted that the costs of regulation, professional indemnity cover and the pensions review would damage the independent advice market. There are no signs of that at present, indeed rather the reverse.

Since I moved into the retail sector when I took over the chair of the FSA I have discovered that IFAs are rather like farmers. Farmers are members of the CBI through the NFU and I discovered during my time there that, according to them, there is never a good year for farmers. The same is true for IFAs, I find. Yet, in retrospect, one can see that they have been growing their share of pensions and life business over the last decade, and indeed the quality of that business, reflected by persistency rates, has been higher than business done through tied sales forces.

I think it would be better for the sector if IFAs were rather more positive about their performance, and I hope that their new trade association, the Association of Independent Financial Advisers, will serve to redress that balance somewhat in the future.

So the general picture as revealed by the numbers of people coming into the regulated financial services sector is one of considerable buoyancy, with volumes up and profits up across most of the sector.

And that is reflected strongly in the business confidence figures which are most reliably found in the CBI/PWC financial services survey. Twelve months ago there was widespread pessimism about business prospects this year, with a strong negative balance on the key question of how people saw business prospects in the next twelve months. That figure went from -27 in December last year to +27 in September this year. Looking forward, the rate of growth in volumes is expected to moderate next year, though not by much. Venture capitalists and finance houses expect falls in business but most other sectors, led by life insurance and insurance brokers, expect significant growth.

In spite of that financial firms expect some slight fall off in employment next year, though it is fair to say that they have been expecting that for some time, and it has not happened.

The financial sector does not, of course, live in isolation from the rest of the economy and strong economic growth is driving much of this buoyancy. But the fortunes of the City do not slavishly follow those of the UK as a whole, given the high percentage of international business in the total.

And when it comes to mobile international business, other considerations apply. Surveys such as those carried out by the World Economic Forum show that firms look at the openness of markets to competition, at the tax and regulatory environment, and at the availability of appropriately skilled staff as key factors influencing their decisions on business location. Transport links, and quality of food offered by the local authorities, are also significant.

At the moment it would seem from the available data that the UK authorities, collectively, must have got the balance broadly right. By that I mean the combination of decisions made by central government, local authorities - in particular the City Corporation - the Bank of England and the regulators now merged into the FSA.

But it’s important that we do not take that balance for granted, and continue to monitor carefully what is going on in the sectors we oversee, to ensure that we do not inadvertently drive business offshore. Fortunately, there are no signs of that at the moment.

There have been some attempts to argue that the introduction of a new regulator would lead to some insensitivity to the needs of individual sectors, and to overall a more heavy-handed approach. Of course there is no proof yet of the way the new legislation will operate, since it has not yet completed its progress through Parliament. But the FSA has been a de facto single regulator for eighteen months now, and there are no persuasive signs yet that we have done any damage to the highly valuable national asset in our care. No doubt you and others will not be slow to tell us if there are signs that our regulatory burden is becoming unreasonable, or imposing anti-competitive burdens on the sector. Indeed, I will encourage you to do so.

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