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Review: II-- Social and structural upheaval

By
MARTIN HUTCHINSON, UPI Business and Economics Editor

WASHINGTON, Feb. 1 (UPI) -- This is the second part of a six-part reflection and commentary on David Kynaston's "A Club no More" (Chatto and Windus, 888 pages, $43), the fourth and final volume of his history of the City of London (the financial district), covering the period 1945-2000. This second part covers the social and structural revolution in the stock market (brokering and jobbing) and in Lloyd's Insurance, when both markets ceased to be "gentlemen's clubs" but failed to compete entirely successfully at the highest international level.

With which of these two Old Etonian stockbrokers, from quotations in Kynaston's book of 1967 and 1984, would you rather do business?

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"Do I work hard? Well, frankly, no. I get down to the office after the rush hour -- about 10:15 -- and I leave just before it, about 4 o'clock. Some keen chaps arrive before it and leave after it, but it doesn't really do them much good. Occasionally, if I've been out at a thrash and got hairy pissers I don't get in till about half eleven. That is a bit idle, but you know it's astonishing the business you can do indirectly by being seen at the right places, like deb. dances and so on."

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"You don't understand these guys. In our world, somebody who gets 1 million pounds ($1.5 million) just wants to make 2 million pounds. These are people who make money, and spend it. If he spends money on parties and racehorses, I say, 'fine' because he will want more. I want a guy who lives well, and is hungry."

If you said the second, you would be wrong, unless you have great confidence in your piranha survival skills. That was Christopher Heath, who put together Barings' infamous Japanese dealing operation that broke the bank. Among the guys who "lived well and was hungry" that he hired was rogue trader Nick Leeson.

Before the 1986 "Big Bang" the City was atomized, rather like a mediaeval "guild" system. Merchant banks, clearing banks, stockbrokers, jobbers, commodity brokers and discount brokers each performed a different function, and each had its own set of social and intellectual attitudes -- the insurance market was completely separate. Within the financial area, trading was concentrated in jobbers; stockbrokers did not trade, nor did merchant banks, except in the money markets. Thus the archetypal "barrow boy" traders were concentrated in a small part of the City's ecosystem, though even in that area there were also a number of upper-class types with capital to employ and a taste for short-term action.

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While some stockbrokers early on, notably Phillips and Drew, concentrated on research, the broking profession in general was pretty un-cerebral, and contained mainly well connected Drones Club types like the 1967 broker quoted above, with an actual or potential base of retail clients, together with a number of middle class strivers (generally NOT likely to end up as Senior Partner) who dealt with the institutions, or acted as primary liaison with the jobbers on the Stock Exchange floor. Stockbroking as a whole was a notably less lucrative profession than either jobbing or merchant banking.

The trading system for stocks, therefore, was one of "single capacity" similar but not identical to that used on the New York Stock Exchange both then and today. Jobbers made the market and took positions, while brokers acted as salesmen, researchers and order takers. Joint ownership of brokers and jobbers was prohibited. The system worked beautifully in preventing conflicts of interest, but suffered because jobbers were intrinsically undercapitalized. With top rates of income tax as high as 98 percent until 1979, and with short-term capital gains from 1961 taxed as income (another blow to the city delivered by the ineffable Harold Macmillan) it was of course impossible for new jobbers to build up capital. As share investment became concentrated increasingly in the institutions (another result of post-1939 tax rates) the result was an epidemic of mergers and disappearances by jobbing firms, the number of which contracted from 237 in 1947 to only 14 by 1979, and the concentration of jobbing capacity in as few as four top tier names. As a leading jobber complained to the Stock Exchange Council as early as 1962, the jobbing system was like "a 1926 vintage Rolls Royce, supreme in outward appearance, with no wheels."

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With the arrival of sensible tax rates in 1979, and still more after the reduction of the top rate of income tax to 40 percent in 1988, this problem would in due course have solved itself, with new firms of jobbers springing up in the entrepreneurial 1980s and 1990s, just as there arose rapidly a network of "local" traders on the new London International Financial Futures Exchange, formed in 1982. Instead, however, the dead hand of government entered the picture, abetted by a feeble Bank of England Governor, Gordon Richardson.

In 1976, the Labor government extended the Restrictive Practices Act to the service sector, giving the Office of Fair Trading jurisdiction over the city. The Stock Exchange rulebook was submitted to the OFT in 1977, which in turn submitted it to the Restrictive Practices Court in November 1979, after the Thatcher government had come to office. The court's wheels ground slowly, but by 1982 it was clear that it objected to single capacity and to fixed brokerage commissions (fixed commissions had been abolished in New York in 1975, resulting in a bloodbath). The court case was due to come to trial in January 1984.

At this point, with the Stock Exchange threatened both legislatively and by the advent of an increasingly strong group of U.S., Japanese and European banks and brokers, Richardson took control and decided on a policy of preemptive surrender. The bank produced a plan under which fixed commissions and single capacity would both be swept away, and the Stock Exchange floor opened up to be run in parallel with a screen-based Nasdaq-type trading system. The one existing system which was retained was "self-regulation"; theoretically, at least there was to be no equivalent of the U.S. Securities and Exchange Commission. The re-elected Thatcher government, glad to be doing something that removed a potentially embarrassing legal battle and appeared to have the backing of the city, abandoned the court case and brought in what became the Financial Services Act of 1986.

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Restrictions on cross ownership between jobbers, brokers and merchant banks were also abolished, which resulted in an orgy of takeovers, as stockbroking partners in particular, appalled by the prospect of a deregulated city, seized the chance to sell out and retire. The new regime itself was instituted by "Big Bang" on Oct. 27, 1986, which swept away both single capacity and fixed commissions.

The results were in many respects a disaster. The new regulatory regime proved both a bureaucratic nightmare and fairly ineffective at catching malfeasance; it was replaced in 1996 by the Financial Services Authority, effectively an SEC. The stock exchange trading floor was abandoned within three months of the change, because electronic trading appeared to be cheaper. It turned out that electronic trading was far more suited to relatively low-skilled operatives within huge financial houses with good risk controls, so both the stockbrokers and the jobbers that had been bought out, all the big ones except Cazenoves, were rapidly swallowed up by the behemoths that had bought them. By the middle 1990's, the London financial market was dominated by U.S., German, French and the occasional Japanese highly capitalized universal banks, with the British presence notable by its absence.

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There is a considerable school of thought, including Kynaston, which says that this was all for the best. The opening up of trading in the 1980's to those with non-elite backgrounds, and the increasing dominance of financial institutions by their trading floors, were both a desirable democratization and an inevitable consequence of technological change. Kynaston regrets only the passing of the brief 1980s age of the "barrow boys," the true East End uneducated traders, in favor of the smooth upper-middle-class MBA's, similar to those that have since the 1970s dominated trading floors in the U.S. investment banks.

The falsehood of this thesis was demonstrated in 2000, with the almost successful bid for the Stock Exchange by the Deutsche Bourse, and the relegation of the London International Financial Futures Exchange to second or even third place in Europe. After all, since Britain is a wealthy country, it is indeed strange that none of the major London investment houses is now British-owned. Maybe indeed the city, far from having cemented its dominance in Europe and its competitiveness worldwide is due to enter a period of decline. After all, there is no longer a distinctive City of London financial culture, no longer an especially flexible regulatory system, and no longer a huge pool of uniquely capable British financiers, either on the corporate finance or the trading sides of the business.

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In the insurance market, the story was similar but in the end even less successful. Traditionally, Lloyd's insurance market operated a unique system, under which wealthy retail investors -- "Names" -- guaranteed but did not invest money in underwriting syndicates. These syndicates in turn underwrote insurance risks, which were placed among them by brokers. Insurance claims were paid by the underwriting syndicates, which had the right to call on the Names up to their entire wealth in the event that syndicate cash reserves were insufficient. The system worked well, provided there were enough Names and the losses suffered by any one underwriting syndicate were not catastrophic.

Because of Lloyd's unique tax status, the high levels of income tax prevailing before 1979 were actually an advantage in attracting Names, since this was one area in which the wealthy could achieve attractive after-tax returns -- indeed, Lloyds' tax status gave it a certain advantage over foreign competition through its lower cost of capital. The management of Lloyds, like that of the Stock Exchange in the 1960's, was very conservative, but by the end of that decade it had become aware that Lloyds was losing out to newly aggressive U.S. and continental European competitors. Its solution, in 1968, was to call in ex-Bank of England Gov. Lord Cromer to head an enquiry.

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Cromer recommended that the minimum wealth to become a Name should be reduced, and that a system of mini-Names, with lesser participation, should be introduced. More important, he proposed that companies should be eligible to become members of syndicates, warned against conflicts of interest between brokers and Names, and warned against the arrogant, potentially corrupt way in which Names were treated by the managers of underwriting syndicates.

Lloyd's management was horrified; the Cromer report was suppressed, not only from the public but from the Names themselves, and only the reduction in minimum Name wealth was carried out. This was a pity. Lloyds eventually carried out all the reforms that Cromer recommended, but twenty years later, after an enormous series of scandals and the bankruptcy of many of the Names through unexpected losses, abetted by wildly irresponsible underwriting activities.

The worst of Lloyds' losses were incurred in the United States, a country in which insurance fraud or near fraud is something of a national sport. In cases such as asbestos, in which liabilities arose decades after the policies had been written, the existence of wealthy foreign insurance underwriters proved an irresistible temptation, time after time, to rural U.S. judges and juries. Consequently, Lloyd's Names, instead of having an attractive, reasonably secure and tax-efficient investment, suffered in some cases enormous losses, and were forced into situations of extreme personal hardship. Locking the stable door after the horse had bolted, Lloyds instituted a series of reforms from the mid 1980s, allowing the entry of corporate capital in 1993.

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It is however unlikely that Lloyd's will survive much longer as a serious competitor in international insurance. Its market share has dropped consistently since 1980, and is now quite small. Its cost advantage over conventional insurance companies has disappeared, or even been reversed, and it continues to suffer substantial losses in the United States. Not only is it a sitting target for the ever wealthier and more powerful trial lawyers, it is also victimized by such tactics as World Trade Center owner Larry Silverman's attempt to claim twice on the same insurance policy after Sept. 11, on the grounds that two, not one, airplanes had hit the complex. Yet again, Lloyd's paid up; the U.S. balance of payments for September 2001 was swollen by $11 billion of foreign insurance receipts, much of it from Lloyds'. Short of "redlining" the United States altogether and concentrating on continental Europe and Asia, there would appear to be no long-term solution to Lloyds' problems.

The decline of the city's financial businesses, on the other hand, could have been avoided had the Thatcher government, instead of assuming that Richardson spoke for the city as a whole, chosen to consult a range of merchant bankers, brokers and jobbers, or better still Cromer, who was still very much around in 1983. Cromer, who had both stronger free market principles and a greater depth of understanding than Richardson, would have told the government a few hard facts and, one hopes, persuaded them to cease meddling, legislatively or judicially, in the delicate mechanism of the City of London.

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Dual capacity did not need to be abolished; it remains in the New York Stock Exchange to this day. The Stock Exchange trading floor should also, as in the NYSE, have been retained -- there is considerable information provided to an experienced broker or trader from the noise and pattern of floor trading. Thus keeping the trading floor would have "tilted the playing field" toward experienced London brokers and jobbers, and away from "barrow boys" and foreigners. Even fixed Stock Exchange commissions could have been retained, although the rise of institutional investors meant that severe reductions were necessary, particularly in the area of "gilts" (fixed income securities). As for regulation, that was perfectly satisfactorily carried out by the Bank of England, aided by the voluntary industry bodies of the Issuing Houses Association, the Accepting Houses Committee and the Takeover Panel.

Of course, even more devastating to London's financial capability than the loss of independent British stockbroking and jobbing was the loss of the merchant banks. That, too, was caused by ineptitude, particularly but not exclusively in the early 1980s; it is discussed in part III through V.


Part III of this review will appear Tuesday.

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