Asia Public Affairs

Submission to IBLAC (International Business Leaders Advisory Council) by Prudential Chairman, Sir David Clementi

September 2006

In recent years, the City of London has consolidated its position as the world's leading international financial centre. According to a poll¹ of financial services practitioners last year, London held a narrow lead over New York , with Frankfurt and Paris a distant third and fourth. Of the world's other centres, Shanghai was ranked “the most promising”.

With this prime position, the UK 's financial services sector makes a strong contribution to the British economy. It accounts for nearly 7 per cent of GDP, it employs over 1m people and generates a trade surplus of $35bn. For comparison, the only country which comes close is Switzerland with a surplus in financial services of $13bn². But London's impact is wider than that. It has been estimated that the economies of scale created by the London “cluster” appreciably reduce the cost of financial services within the European Union as a whole, and beyond ³. When people refer to the City, they are talking about far more than a collection of skyscrapers beside the River Thames.

London's strengths are evidence of the enormous potential that a successful financial centre can create for jobs, economic growth, and a country's standing. The reasons behind London's success are therefore worth close study, particularly in a city like Shanghai which has set itself the objective of becoming an important financial centre within the context of China's overall strategy for development and innovation.

Some of London's strengths are what one might call “environmental”; for example its disciplined but flexible regulatory system with its emphasis on probity and fairness as well as on a light touch. London also benefits from the dominance of the “Anglo-Saxon” culture in international finance (including the use of the English language).

Many of the reasons for London's success are also historical: London has a strong tradition of international commerce in a wide range of markets, including commodities, insurance, shipping and capital. More recently, London has emerged as the world leader in the trading of currencies and international bonds and equities. It has also taken the lead in new markets such as hedge fund management and venture capital (see Table 1).

But London would never have capitalised on these strengths if it did not also have a strong record in the field of innovation. International finance is an intensely competitive business, and the ability to stay at the forefront is vital to success.

London has shown a strong record of innovation, in two senses.

One is in generating new ideas, by which we mean using innovative techniques to develop new products and markets. Recent examples include new types of derivatives, private equity and the new-fledged markets for carbon emission permits. Equally important is London 's ability to attract top people by offering strong professional foundations and challenging careers. It would be no exaggeration to say that any young person with ambitions in international finance these days would want to spend time in London to gain training and experience.

This paper examines the role that innovation plays in London 's position as a financial centre, in particular the growing synergy between the City and the academic world as a source of people and ideas. The paper draws on the City's experience in this area to make proposals for other emerging financial centres seeking to encourage innovation.

Ideas
There was a time - not long ago - when the financial services industry was distinguished by its lack of innovation. Banks made loans, insurance companies insured things, stockbrokers bought and sold shares for clients. There was little exchange of ideas, restricted competition and little drive for innovation.

That, of course, has completely changed. Thanks to deregulation and the emergence of exciting new technologies, finance is now one of the most competitive, innovative and fast-growing industries in the world. In fact there are few areas of the industry, whether you look at it in terms of sector, function or product that are not constantly striving to come up with something new.

One of the strongest drivers behind innovation has been the trend towards what one might call “financial science” – the use of scientific methods to create more efficient – and safer – businesses.

Here, a key development has been the arrival of what is popularly called “rocket science”, the deployment of quantitative methods to measure financial risk and return.

In the past, financial trading was largely driven by personal judgment and speculation. Today, trading is increasingly about the measurement of risk, using high-powered number-crunching techniques to price securities and take trading positions. This can include anything from the analysis of interest rate trends to the impact of global warming on economic activity, even to the likelihood of the world being struck by an asteroid. The massive growth of trading in derivative instruments, now the most powerful force in the markets, has been particularly dependent on quantitative techniques. The financial models that support business decisions are also increasingly rooted in financial science.

By the same token, financial science has been instrumental in advancing modern forms of financial regulation. Where, in the past, the City's regulators kept banks and traders in order with a set of informal rules, they now use quantitative methods to calculate the amount of risk that financial institutions are exposed to, and how much capital they need to put behind it. The new global capital regime for banks known as Basel 2 uses these techniques, which means that quantitative finance now underpins the world's banking system.

Although quantitative finance looms very large, other areas of financial science are also having a big impact. Information technology, with its heavy dependence on networks, communications and systems is an obvious example. So is financial modelling. Scientific methods are also being applied to areas like security (encryption), fraud prevention (identifying unusual trading patterns) and customer relations management (anticipating demand).

The investment banking sector is probably the largest consumer of financial science, but other parts of the finance sector are also deeply interested. Commercial banking now uses scientific methods to manage credit risk and track consumer demand. The asset management sector uses it to measure portfolio performance and price securities. The insurance industry is a fast-growing consumer through its interest in risk pricing and customer management.

In the professions, the actuaries have been among the most active because of their interest in life expectancy. But the growth of financial science has also been of interest to accountants and consultants. Indeed a large consultancy profession has sprung up around financial science to help people understand it and apply it to their businesses.

Science has therefore become not just the foundation for a wide area of very sophisticated financial business, but also the source for innovation and future development. This has made the City and its regulators keen to have access to the latest developments in the field, and has greatly strengthened what were traditionally rather weak links between the UK financial services sector and academia.

The role of the universities
In the UK we are fortunate to have many universities and research institutes with strong quantitative faculties. Some of these are located in London itself, like the City University (with its Cass Business School ), the London School of Economics, Imperial College and the London Business School . Others lie further afield but have strong links with the City: in particular Oxford , Cambridge , Warwick and Reading Universities. These institutions have responded to the City's demand for financial science by greatly expanding their work in this area; for example by creating targeted research programmes and establishing specific research departments in quantitative finance and related fields. Some have also set up consultancies to provide expert, independent advice on what are often extremely sophisticated and difficult subjects.

The university funding councils (the means by which public money is channelled into the universities for research and post-graduate training) have also created themed programmes to back research into City issues. By way of illustration, the Engineering and Physical Sciences Research Council, one of the UK 's leading scientific funding bodies, has identified the financial services sector as a key target, with a focus on five areas:

Security. Encryption, security for e-trading and networks, authentication, fraud prevention, forensics, biometrics and surveillance.

Risk management. Forecasting and modelling tools to improve the predictive capacity of financial institutions, statistical risk measurement theory and practice.

Systems and networks. Communications and network management technologies relevant to financial services.

Business data analysis. Techniques for customer relationship management and supply chains, and the identification of inconsistent data as a management tool.

Financial modelling. Techniques for improving quantitative finance models.

The funding for these five areas is distributed as shown in Table 2. Although the overall numbers are relatively small, these show that research into systems and networks receives much the largest share, reflecting the technical nature of the EPSRC.

One interesting observation⁴ is that the academic skills needed for financial science need be neither financial nor economic. The requirement is usually for work of a highly disciplined mathematical nature for which physics departments have proved just as adept as economics, if not more so. It is significant that the above funding example concerns the council responsible for funding scientific research, not one of the councils responsible for economic or social sciences which one might have thought more likely.

As this shows, the drive for a closer relationship between the City and academia has come from both sides, giving it a strong two-way flow which confers mutual benefits. Academia supplies the research needed to underpin advances in financial science. The City contributes to funding and gives feedback on promising research areas. These links are sustained by contact at many levels, between management and the university authorities, between research departments and between individuals, some of it formal through seminars and conferences, but much of it informal via personal contact. There is also a large and widely disseminated academic literature in this area, as well as trade journals which aid the flow of ideas.

However, the relationship is a challenging one.

For a start, it has to be recognised that the interests of the City and academia do not coincide. The City is short-termist, competitive, and interested in business applications, while academia takes the long view, likes to share its ideas and spends as much of its time on theory as it does on practice. There is therefore little appetite – or funding – available in the City for fundamental research in these areas, much to the chagrin of academia which feels under-appreciated. Nonetheless, this does have the effect of putting pressure on academic researchers to ensure that their work is commercially relevant. Even so, there are far-sighted firms in the City who understand that fundamental research is vital not just to underpin current innovation but to lay the ground for the future.

Another obstacle lies in the area of competition. City firms have proved reluctant to finance academic research which might be used by their competitors – understandably. It is true that some City firms commission private work from universities, but this practice causes disquiet because of the potential for compromise, and is not encouraged in academia. Often, financial firms prefer to “buy in” talented individuals from universities to generate exclusive in-house research, rather than contribute to outside work which will also benefit business rivals. The ability of universities to produce top level, practically-minded researchers is a key issue.

The focus of City funding for academia has therefore been on “pre-competitive” research, i.e. work which can be exploited by all market participants for the general good. Much of this falls into the category of “Making the world a safer place”, e.g. regulation, operational risk management and fraud prevention, and for this reason it is also encouraged by the regulators.

A further point needs to be made, about geography. Although the focus of this paper has been on the City's relations with British academia, the full picture is much wider than that. The City is a truly international financial centre in close contact with all parts of the world: it lies at the heart of the global marketplace for ideas. And there are no barriers to these ideas. Rather the opposite: new products and techniques flash round the world in an instant, and are rapidly exploited because of the absence of patent protection for new financial products. The City therefore draws strongly on research and innovation produced by other countries, in particular the US which is still the world leader in the area of financial science. So although the City's links with British academia may be strong, they are not specially close, let alone exclusive. Again, this adds to the pressure on the British research establishment to ensure that its work is relevant and of top quality.

So changes in the finance sector have given a top place to innovation, for which academia can provide both the fundamental research and the applications. But the success of the relationship between the City and the academic world lies in recognising that each have very different interests.

People
As finance becomes more technical and competitive, the need has grown for highly qualified individuals with a good understanding of the business and proven skills at all levels within financial firms.

In recent years a large industry has emerged in the UK to train people for careers in finance – offering everything from vocational diplomas to PhDs. This is supplied by both the public and private sectors.

Universities have developed a wide range of research programmes, post-graduate degrees and MBAs in various aspects of finance. While most of these are funded by public money, some have been sponsored by the industry, notably the ICMA Centre at Reading University which receives funding from the International Capital Markets Association and qualifies several hundred students a year with graduate and post-graduate degrees in investment banking, financial regulation, quantitative finance etc.

The private sector has also risen to meet demand, more in the area of vocational qualifications such as diplomas and technical skills. A major role is played by professional bodies such as the Institute of Financial Services , the Securities and Investment Institute, the Chartered Institute of Insurers and the Chartered Institute of Investment Managers, all of which now offer courses and professional qualifications of many kinds. Related professional bodies representing the chartered accountants, the actuaries and the corporate treasurers are also important to the process.

Because demand for this form of education is worldwide, professional training and qualification have become a major UK export industry. The importance of this business has been recognised by the government which has put education at the forefront of its policy agenda. It is also to be the leading theme of the next Lord Mayor of the City, Alderman John Stuttard, under the banner “City of London , City of Learning ”.

The availability of training and job experience has made London a magnet for young people from all over the world seeking careers in finance. According to a recent poll⁵, London is now viewed as the best city to obtain an educational qualification. This influx has had a big impact on the composition of the City. According to the City Corporation, over half the workforce in the financial and business services industry now comes from outside the UK , and over half are under 31 years of age. While the majority of these new arrivals are European and North American, the fastest-growing share is from the Far East.

But although all this means that the City can no longer really be described as “British”, the fact that it has a strong academic research and educational background adds greatly to its appeal and its credibility. It has access to the latest ideas, its innovations are solidly rooted, and the disciplines of research are robust. This helps generate a challenging and rewarding atmosphere.

Policy issues
Finance is one area where the accusation frequently levelled against the UK (that it produces new ideas but fails to capitalise on them) is not apt. The City has proved to be highly innovative. This is partly because it attracts strongly motivated people and generates a hotly competitive environment. But it is mainly because the City, while geographically located in London , is in reality an international community where national characteristics have little play. This is, in itself, one of the drivers behind the City's success, and should be the objective of any aspiring financial centre.

However this does raise public policy questions.

One is the extent to which government should become directly involved in developing a financial centre. That may seem an odd question since government clearly has a decisive influence through its control of regulation, taxation and so forth. Yet one of the key attributes of a successful financial centre is a reputation for independence, a perception that it operates commercially, free from political interference. Although few British governments have been able to resist the temptation to “manage” the City at some time or other, they have, on the whole, respected the City's need for independence. The same goes, of course, for the independence of the academic world. Our present government sees the value of having a vibrant and prosperous financial centre. The government recently launched a “City Competitiveness Initiative” spearheaded by the Treasury and UK Trade and Investment to promote the City's services, but the governance of the City itself remains very much in local hands.

Another tricky question is why a country should invest in financial science if the fruits of research are so quickly dispersed across the globe, to be exploited by other centres? Can anything be done to retain the benefits locally? This is a dilemma, but the reality is that little can be done to keep research “local”. A country must be prepared to see research dispersed. But offsetting this is the consideration that a successful centre benefits as much from research funded by other countries as it does from its own. And the over-riding consideration is that strong academic backing and the availability of training give a financial centre credibility and help attract good people, and that is vital.

By the same token, the brightest people in finance do not feel tied to geographical countries or centres, but will seek out the best opportunities anywhere. A country therefore has no guarantee that the people it trains up at great expense will repay the cost by remaining in the neighbourhood. This is one of the risks. But a successful centre will also attract expensively trained people from other countries, and benefit accordingly. Indeed, emerging centres will probably do best initially by actively seeking to draw in people with training and experience gained from more highly developed financial centres.

For a new market like China , the presence of a strong academic framework producing commercially-relevant research and top quality training will add greatly to its status as a financial centre and strengthen its chances of success. It will also give it a competitive edge at a time when several new financial centres are vying for a share of the market, e.g. Dubai and Mumbai. But as this paper has tried to show, the relationship between academia and the finance sector is delicate and needs careful management by both sides.

There are also public policy issues which need to be addressed with the understanding that financial centres operate in global markets, and that much of their reputation depends on intangible qualities such as openness and independence. This is an area where government can often do best by providing resources and a good operating environment, but then standing back and allowing the centre to generate its own appeal.

¹ Z-Yen. The competitive position of London as a global financial centre. Corporation of London November 2005.
² Statistics for 2004 compiled by International Financial Services London.
³ CEBR. The importance of wholesale financial services to the EU economy 2005. Corporation of London April 2006.
⁴ David Lascelles. Quant and Mammon . CSFI . 1998
⁵ Anholt-GMI City Brands Index. December 2005.

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