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London's great debate: Can it survive as a financial hub?

December 16, 2011: 10:39 AM ET

Love it or hate it, Prime Minister David Cameron's decision to isolate Britain from the European Union and protect its bankers has brought London back into the international spotlight.

By Katherine Ryder, contributor

london_canary_wharf

London's Canary Wharf

FORTUNE -- In London, bankers are everywhere -- at least for now.

They are in the "The City," the English answer to Wall Street. Banks and asset managers line narrow streets surrounding St. Paul's Cathedral, with upscale fast-food lunch places around every corner. They have colonized Canary Wharf, a distinctly un-British enclave composed of underground malls, enormous skyscrapers, and large empty swaths of pavement. They have even taken over much of Mayfair, near London's best restaurants and private clubs, where hedge funds now house themselves in charming three-hundred-year-old row houses.

When British Prime Minister David Cameron arrived in Brussels last Thursday for the EU Summit, the demands he brought were to protect these three pockets of London from European regulation. And why not? Finance is one of the bedrocks of the British economy. On a national level, financial services contribute an estimated 10% to British GDP. And with the economy in doldrums, now more than ever, the U.K. needs every lever at its disposal.

Even if Cameron's goal was sound, his tactics weren't, well, tactical. Asking for special treatment when German Chancellor Angela Merkel and French President Nicolas Sarkozy were under pressure to find common ground and essentially save the European economy was less than politically astute. By the end of a long night, Cameron sat alone while the remaining 26 EU members agreed to move together towards a "fiscal compact."

A great debate has now erupted in London over whether Cameron made the right move to "isolate" Britain, in the parlance of his fellow politicians.  Cameron's anti-European conservative supporters called his veto a Churchillian moment. His critics compared him to Neville Chamberlain, the British Prime Minister who wanted to negotiate with Hitler during World War II.

Defending the banks

Cameron's claim is simple: That Britain's biggest challenge when it comes to the eurozone crisis is making sure that the profitability of London's financial sector remains intact. Yet given the backdrop -- Occupy London protestors sleeping in the City in tents and leading "villain tours" through Canary Wharf -- the point isn't uncontroversial. Most British are still angry at the reckless years of high finance, the ensuing financial crisis, and its ravaging effects across the economy.

Yet Cameron's stand fits within a long history of British politicians bending over backward for banks. In the 1960s, after the U.S. enforced harsh regulation on Wall Street, the U.K. welcomed American banks and other foreign firms by keeping regulation light and work permit requirements relaxed. The effort was a striking success. London now has the largest global cross-border bank lending market, foreign exchange market, and over-the-counter derivatives market. One out of three dollars managed in the city is foreign. In 2010, the World Economic Forum declared London to be the world's leading financial center.

Why can't Europeans get along?

The global financial crisis and its reverberations in lending markets were bound to weaken any democracy with finance as its strongest export. Regulations in the City have tightened—banks now have to hold more capital, and the richest financiers, whether English or foreign, have to pay a lot more in taxes. The primary present concern of the banks, however, is Brussels, not London. The FSA, Britain's financial regulatory authority, says that around 70% of its policy-making efforts are driven by European initiatives that are not geared toward preserving London as a financial center.

The problem underscores the entire dilemma with the European Union: the idea of sharing sovereignty among very different regimes. For the European Union to survive, Germany and France want to impose tough austerity measures, in many cases targeting banks. The EMIR--the European Market Infrastructure Regulation--aims to shrink London's derivatives market. The most disturbing idea to London is a financial transaction tax, which will dramatically increase the cost of doing business for every bank.

The European Commission says such a tax would raise $75 billion per year. But since more than a third of Europe's wholesale finance market operates out of London, England would end up footing 80% of the bill, according to a damning speech by UK Chancellor George Osborne.

More broadly, there is a strong sense in the UK that European financial regulation is disproportionate: "England regulates its banks. Europe punishes theirs," says Dr. Andrew Hilton, director of the Centre for the Study of Financial Innovation.

Cameron's veto, however, also represents a broader source of British political discontentment—one that stems from the UK's steadily declining place in the world. England still has world-class institutions, companies, and culture, but it's a country of 60 million without any major export except financial services. A consensus now seems to be forming that if Cameron had agreed to move forward with the "fiscal compact" -- which has few concrete details and will likely continue to be renegotiated for months, if not years -- he might have been in a better position to get what London wants.

Why Germany needs the euro

Still, his veto, which stoked the tension between the French and the British, might prove to be an aside of this entire crisis. Merkel, Sarkozy, and Cameron all smiled for cameras and publically proclaimed this week the importance of having Britain in the EU. This may well represent the blunt reality that a dissolution of the euro would be much more painful for the British economy than incremental increases of financial regulation.

And what does the future hold for London's bankers?

Already, many of them have caught the hook. Around 27,000 people working in finance in London have lost their jobs this year, according to the Centre for Economics and Business Research. Given the environment, fears of regulation now commonly play second fiddle to more fundamental fears of insolvency.

And whatever happens in the eurozone, it seems unlikely that the City or Canary Wharf will simply fade. "London has the benefit of the end of Asia's trading day, the opening of America's trading day, and a market in English," says one fund manager. "I make less money now than I did in 2006, but where else would I go?

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