|File documento allegato||Sep 23rd 1999 |
From The Economist print edition
The City of London’s revival over the past few decades mirrors the wider growth of the financial-services industry. But Peter Drucker argues that the industry will need a radical shake-up if it is to survive and thrive*
THE rebirth in the past 40 years of London’s City as a world financial-centre is as impressive a success story as is Silicon Valley. The City today is not nearly as powerful or as important as it was in the 100 years between Waterloo and the first world war. Still, today’s City, through its interbank market, is the banking-system’s “central banker” worldwide. It is the world’s largest foreign exchange market. The money for medium-term financing (eg, “bridge loans” or the financing of mergers and acquisitions) may be raised in America, but more often than not the structure of these complicated deals is being worked out in London. Even in long-term financing such as underwriting, the City is outranked only by New York.
Yet in 1960, no one would have expected the City’s resurgence. After 50 years of steady decline it was then considered almost irrelevant even by many people in the City itself.
To some extent the City’s turnaround was made possible by two American events, both occurring during the Kennedy administration. At the time of the Cuban missile crisis, the Russian State Bank, afraid of having its American accounts frozen, shifted its foreign reserves into London. But the Russians wanted to keep their money in dollars. And thus the Eurodollar was born—a transnational currency denominated in dollars but domiciled in London. Shortly thereafter the American administration—foolishly—put a punitive tax on payments of interest to foreigners, thus destroying in one fell swoop the flourishing New York foreign-bond market. It fled, giving birth to the Eurobond—again denominated mostly in dollars but domiciled and controlled in London.
These American events only created an opportunity. London bankers—and especially S.G. Warburg—seized it. Indeed S.G. Warburg, a firm started only in the 1930s by two German refugees, had, even earlier, in 1959, brought an entrepreneurial form of banking to London when it began to finance acquisitions. Until then this kind of entrepreneurial finance had for 75 years been an American speciality (ie, since J.P. Morgan in the 1880s).
But the key factor in the City’s rebirth as a financial centre was its recovering its 19th-century position as the headquarters for financial institutions from all over the world. The 19th-century City was the creation of an earlier immigrant from Germany, Nathan Rothschild. After the Napoleonic wars, he invented the capital market by financing the governments of Europe and of newly independent Latin America through bonds underwritten in London, placed in London, and traded on the London Stock Exchange. He was soon followed by a host of other immigrants—Schroder (Germany); Hambros (Norway); Lazard (France); Morgan (America)—to name but a few.
These newcomers typically founded English firms and many became British themselves. But together with some of the older English-born “merchant bankers” (such as Baring Brothers, a bank founded by the sons of a German emigrant in 1770), they created a truly global financial centre.
What attracted these immigrants was not just that England was the 19th century’s foremost trading country. It was that London soon became the world’s foremost financial-knowledge centre (as Walter Bagehot first pointed out in his 1873 book, “Lombard Street”). This too was largely Nathan Rothschild’s invention and legacy. The five Rothschild brothers—each stationed in a different European financial capital, but all five acting as one firm with Nathan as the chief executive—were an early “intranet,” with their famous carrier pigeons a pre-electronic “e-mail”. To this day, despite all the vicissitudes of this century, the City has remained the sole worldwide knowledge centre for business, finance and economic affairs. And it is the City as transnational knowledge centre which, in the 1960s and 1970s, again attracted “financial immigrants” to London from all over the world. Legally, their London establishments are wholly owned subsidiaries or branches of an American, Swiss, Dutch or German parent. But in economic reality these subsidiaries tend to be separate and largely autonomous, that is “headquarters”. It is a common saying on Wall Street that the New York office, whether of Goldman Sachs or of Citibank, is primarily concerned with the firm’s domestic business. The firm’s international business is largely directed out of London.
A wider transformation
The rebirth of the City was, however, only the first chapter in the success story of financial services in the past 40 years. That this is a new industry is largely concealed by the fact that many of its big players bear old, and often 19th-century, names. But the Goldman Sachs of 1999 is a very different business from the Goldman Sachs of 1899, of 1929, or even of 1959—and so are J.P. Morgan, Merrill Lynch, First Boston, Citibank, GE Capital, or any of the other big firms, whether American or European. Even in 1950 all these were still domestic institutions.
It may be indicative that when I first came to the United States from England in the mid-1930s, only two of the top New York banks—Manufacturers and Guaranty Trust, both long gone through mergers—had an executive in charge of foreign business, and neither ever made full vice-president. The only things these two “assistant VPs-international” then did was to issue letters of credit to American exporters and to provide importers with foreign currency. Anything beyond that was sent to a “correspondent bank” in the foreign country.
Even the few financial firms which then had establishments outside their home country (as both Deutsche Bank and what is now Citibank had in South America) used these “branches” primarily to serve their own domestic clients. “Our first job”, the head of one of the most prosperous South American branches of what is now Citibank said to me in the early 1950s, “is to be to American business what American Express is to the American tourist.”
But today all these firms have become global and operate “transnationally”. They are everywhere, in all the main business capitals. Every main establishment is a headquarters in its own right. Its mission now is no longer to serve the domestic customers of its parent. It is to become a major player in both the domestic and the international business of the country in which it is located.
Equally radical is the change in the business itself. These financial-services institutions are neither commercial bankers, nor investment bankers, nor merchant bankers, nor stockbrokers—the typical financial businesses of 1950. Some still offer the traditional services—but few try to push them. In fact, today’s main financial-services products barely existed at an earlier time. Some examples: managing and financing mergers, acquisitions and divestitures, both friendly and hostile; financing equipment leasing worldwide; financing the global expansion of manufacturing and commercial companies. And there was nothing remotely like the enormous business in currencies now generated by world trade and investment.
While the new financial-services industry began with the rebirth of London’s City in the early 1960s, it soon became world-wide after 1970. But despite its success—indeed largely because of it—the industry will have to reinvent itself if it is to continue to prosper in the 21st century. The products that fuelled its growth—beginning with the Eurodollar and Eurobond, that is with the re-birth of London’s City—can no longer sustain it. Forty years ago they were innovations. Now they have become “commodities”, which means they have become increasingly low-profit, if not unprofitable. And for each deal there seem to be many bidders. The one who snares the deal may make lots of money despite his heavy expenses. But others have only the expenses. So more and more of the income of the top firms—whether owned by Americans, Germans, Dutch or Swiss—no longer comes from fees that clients pay for services. It comes from trading for the firm’s own account—in stocks and bonds, in derivatives, currencies and commodities.
Every financial-services firm has to do some trading for its own account. It is a routine part of managing the firm’s own finances and is aimed at minimising risk, eg, by bridging gaps between the maturity dates of what the firm owes and what is being owed. Beyond this a certain amount of trading for the firm’s own account can and should be profitable with minimal risk; it exploits the firm’s knowledge of the markets. But when trading for a firm’s own account becomes a big activity, it ceases to be “trading” and has become “gambling”. And no matter how clever the gambler, the laws of probability guarantee that he will eventually lose all he gained, and then a good deal more.
This is already happening to the leading financial-services firms. Almost every big firm has by now reported substantial “trading losses”. In several cases the losses have been so heavy as to kill the firm. One example is Barings, the world’s oldest and most respected London private bank; what is left of it is now owned by a Dutch financial group. Similar trading losses forced New York’s Bankers Trust—not so long ago one of the most respected international banks—to sell itself to Germany’s Deutsche Bank. Several Japanese financial giants survived their trading losses (eg, Sumitomo speculating in copper) only because Japan Inc came to their rescue. But even Japan Inc could not save Yamaichi, one of the largest Tokyo stockbrokers, from losses it incurred by trading in property for its own account.
In every single one of these trading losses, the firm’s top management has claimed that it knew nothing of the gambles, and that the gambling trader violated the firm’s rules. But in the first place there is a limit to coincidences. Such widespread breakdowns cannot be blamed on “exceptions”. They denote systems failure. But also, in every single one of these “scandals”, top management seems carefully to have looked the other way as long as trading produced profits (or at least pretended to produce them). Until the losses had become so big that they could no longer be hidden, the gambling trader was a hero and showered with money.
No industry can survive, let alone prosper, unless it is paid for services rendered to others, that is, to outside clients and customers. But the customers of the financial firms that trade for their own account are other financial firms trading for their own account. And this is a “zero-sum game” with one firm’s gains being another firm’s losses—and nothing left over to pay either’s expenses.
There is still one area for genuine growth in present financial services: Japan. Its financial system is still largely pre-1950 and thoroughly antiquated. Japan is slowly allowing foreigners in to provide modern financial services; and whenever they have been let in, the foreigners—primarily Americans, but also Germans, French and British—have fast become successful and leaders. They are, for instance, the key players in Tokyo’s foreign exchange market. Similarly, foreign firms increasingly handle the non-Japanese investments of Japanese pension funds and insurance companies—and they may soon be allowed to become Japanese pension-fund managers themselves. And an American firm, Merrill Lynch, can now serve both retail and institutional investors in Japan, thanks to its purchase of Yamaichi.
But Japan could be the “last hurrah” of the financial-services industry in its present form. In volume, demand for the products of today’s industry may grow in the next few years as European and Asian industries speed up their restructuring—still far behind America. But the industry’s profitability is unlikely to recover. The industry’s traditional products and services have been around so long that there is an oversupply of people and firms proficient in them. There is thus less and less true differentiation between what different financial-services firms can offer. The customers know it and are increasingly shopping around for the best deal.
Time for innovations
The reason that the financial-services industry is in trouble is quite simple. The dominant financial-services institutions have not made a single major innovation in 30 years.
The two decades between 1950 and 1970 brought one innovation after the other. The Eurodollar and the Eurobond were just two of them. There was the institutional investor—started off by the creation of the first modern pension fund, the General Motors fund in 1950, which set off a veritable boom in corporate pension funds but also turned the then still marginal mutual fund into a central financial institution. Within a few years this led to the foundation of the first firm specifically designed to service new institutional investors: Donaldson, Lufkin and Jenrette, in New York. At roughly the same time, Felix Rohatyn in New York (now American ambassador to France) invented the new role of the private banker as initiator and manager of acquisitions, especially of hostile ones.
The 1960s saw also the invention of the credit card—now ubiquitous and becoming “legal tender”, especially in the developed countries. It is largely the credit card that has enabled commercial banks to survive even though much of their traditional business of commercial loans has been siphoned off by the new financial-services institutions. The remaining innovations were both made by Walter Wriston (born 1919) shortly after he became head of Citibank in 1967. He almost immediately changed his company from being an American bank with foreign branches into a global bank with multiple headquarters. And his insight, a few years later, that “Banking is not about money; it is about information,” created what I would call the “Theory of the Business” for the financial-services industry.
Since then, 30 years ago, the only innovations have been any number of allegedly “scientific” derivatives. But these financial instruments are not designed to provide a service to customers. They are designed to make the trader’s speculations more profitable and at the same time less risky—surely a violation of the basic laws of risk and unlikely to work. In fact, they are unlikely to work better than the inveterate gambler’s equally “scientific” systems for beating the odds at Monte Carlo or Las Vegas—as a good many traders have already found out. Otherwise, however, there have only been minor improvements—doing a little better what was already done quite well. As a result, the industry’s products have become commodities and increasingly both less profitable and more expensive to sell.
This is, of course, what both economic theory and experience could have predicted. In fact, the trajectory of the financial-services industry is a textbook example of the two classic innovation theories, that of the French economist J.B. Say in his 1803 book, “TraitÚ de l’economie politique” (Treatise on Political Economy), and of the Austro-American Joseph Schumpeter in his 1912 book, “Theorie der Wirtschaftlichen Entwicklung” (Theory of Economic Development).
Say explained, at the outset of the Industrial Revolution, why there could not be too many cotton mills using the new inventions of the spinning jenny and steam engine, and all of them hugely profitable. He showed that such inventions in the beginning create their own, insatiable demand, and thus create in their early stages higher profitability for all, the more of them there are. Schumpeter, a little over a century later, then showed that this stage cannot last long for the simple reason that the high “innovator’s profit” soon attracts too many imitators. The industry then changes from one making and selling highly profitable products and services to one making and selling profitless commodities, even if demand still remains strong.
There are now only three possible roads the financial-services industry can take. The easiest, and usually the most heavily travelled, is to keep on doing what worked in the past. Going down this road means, however, steady decline. The industry may survive—there are still plenty of cotton mills, after all. But no matter how hard it works, it will keep on going downhill.
The second road is for the industry to be replaced by innovating outsiders and newcomers—Schumpeter’s “creative destruction”. This is basically what happened to the old London “City” 35 years ago. Except for Rothschild and Schroders, not one of the leading City firms of 1950-60 is still in English hands, not even Warburg. All have become wholly-owned subsidiaries of foreign firms: American, Dutch, Swiss, German, French.
For today’s financial-services industry, the first road is surely not open. There is far too much change going on in the world—social, economic, technological, political—for a major but ailing industry to be left alone. There is far too much money to be made by taking pieces of lucrative business away from the struggling giants, especially those that are preoccupied with trading to the neglect of their legitimate businesses. And with websites and e-commerce, it is easy for outsiders to enter the industry if they have something new and truly different to offer.
The second road—to be replaced, and probably fairly rapidly, by outsider innovators—remains a possibility for today’s firms. But there is also a third and final road—to become innovators themselves and their own “creative destroyers”.
There is no lack of opportunities for new and highly profitable financial services. Indeed the biggest—and probably most profitable—opportunity does not require innovation at all. It requires only hard work. It lies in demographics, that is in serving the new and different financial needs of the rapidly growing affluent and ageing middle-class in developed and emerging countries. These people are not “rich” and are thus not attractive customers for the traditional financial firms. But while their individual purchases are relatively modest—rarely more than $30,000-50,000 a year per family—the sums they collectively pour into investments dwarf by several orders of magnitude everything all the world’s “super-rich” together have available, including oil sheikhs, Indonesian rajas and software billionaires.
This market was discovered 30 years ago by Edward Jones, a then minuscule and totally obscure provincial brokerage firm in St Louis, Missouri. When he discovered this market, Edward Jones decided to drop all other business and exclusively serve the individual, middle-class investor—small-business owners, middle managers, successful professionals and so on; and to sell nothing not appropriate to this group. It is now a major national firm and has been highly profitable all along. And that this market is not confined to America, Edward Jones proved when, a few years ago, it went into England and opened offices in small towns around London. Totally unknown, and with an approach to business, to investments and to customers that was—and still is—new, it found an immediate response.
The Jones-type of customer constitutes the fastest-growing population group in every developed and emerging country. In addition to North America, this includes all of Europe, the most populous countries of Latin America, Japan and South Korea, but also the metropolitan areas of mainland China—close to half of the human population.
This market might become the 21st century’s successor to the world’s first financial “mass market”: life insurance. By providing financial protection against the major 18th- and 19th-century risk of dying too soon, life insurance became the biggest financial industry of that century, growing profitably worldwide for more than 150 years, ie, until 1914. Providing financial protection against the new risk of not dying soon enough may well become the next century’s major and most profitable financial industry.
Here is another example—but one where the business has yet to be built: being the “outsourcing” and financial manager for medium-sized businesses. Except in Japan and South Korea, medium-sized firms dominate all developed economies—but also the emerging economies, whether in Latin America or in Taiwan. The 80,000 Mittelstand (ie, medium-sized) businesses are the backbone of Germany’s economy. And similar businesses are also the backbone of the American, French, Dutch, Italian, Brazilian and Argentinean economies.
In terms of products, technology, marketing and customer service, they usually have the needed critical mass. But in financial management many—perhaps most—do not have the size to support the competence they need. Typically, for instance, they operate with a woefully low productivity of capital and have either too little or too much cash. An increasing number already outsource their data processing and information systems; their housekeeping; their routine personnel management; and even a good deal of research and product development. How long will it be before they are ready to outsource the management of the money in their business?
The tools for doing this work are fully developed, eg, EVA (economic value analysis), or cashflow forecast and cashflow management. The financial-management needs of these businesses are predictable. And worldwide they fall into a small number of categories, well-known to any experienced commercial banker. The rewards for building a firm providing these medium-sized businesses with financial management might be enormous—not only from fees but also through substantial profits from “securitising” the financial needs of the clients, ie, converting them into investment products that should be particularly attractive to the ageing middle-class “retail” investor.
A final example of a potential opportunity for new financial services: financial instruments that protect a business against catastrophic foreign–exchange losses by converting currency risks into an ordinary cost of doing business, with an affordable and fixed premium, maybe no more than 3-5% of a firm’s currency exposure. Again most of the knowledge for such an instrument—half insurance, half investment—is largely available: the actuarial concepts to determine needed sample size and risk mix; the knowledge of risk management; the economic knowledge and data to identify endangered currencies, and so on.
The need is desperate—again, mostly among the world’s huge numbers of middle-sized businesses that suddenly find themselves exposed to a chaotic global economy. No business, except an exceptional very big one, can protect itself against this risk by itself. Only aggregation, which subjects the risks to probability, could do so. And again, such a financial-services firm would also be able to “securitise” its portfolio and thereby create attractive investments for the new financial retail market.
These are just examples and—except for the already existing and already served retail market of the affluent ageing—still hypothetical ones. If they were developed, however, they might have tremendous impact on existing financial-services institutions. Outsourcing financial management of middle-sized companies might, for instance, wipe out practically overnight a good deal of the most profitable business of such financial-services companies as GE Capital. Making catastrophic currency risk insurable might similarly make obsolete most of the foreign-exchange business of existing institutions, let alone their frantic currency trading and speculation in derivatives.
After 25 years of pooh-poohing the middle-class investment market, some of the traditional American financial-services institutions have lately come to accept its existence and importance. Merrill Lynch, for instance, is aggressively moving into it. Whether this will work still remains to be seen. It is quite likely that—as in many other retail businesses—success in this market demands exclusive concentration on it; and Merrill Lynch is trying to combine being the financial-services provider for this highly distinctive market with offering a host of other, and mostly very traditional financial services.
But outside of this market—which is, after all, now 30 years old—there are no signs that any of the large global financial-services firms is even experimenting with these potential new businesses or with anything else that might be an innovation. These new businesses require long years of patient, conscientious hard work—and that may not fit the trader’s mentality that now seems to rule the big and dominant financial-services firms. Yet it is highly probable—indeed almost predictable—that somebody, some where is already working on these, or similar new financial services which, when introduced, will replace, or render unprofitable, today’s financial services.
It may not be too late for the existing big financial-services firms to become innovators again. But it is surely very late.
* Peter Drucker, a native of Austria who will celebrate his 90th birthday in November, has been writing about economics, management and current affairs for seven decades: first in Germany, then England and, since 1937, in the United States.