Global Financial Centers

Saskia Sassen. Foreign Affairs. Volume 78, Issue 1, January/February 1999.

The trans formation of global capital markets into a new supranational order is continuing apace despite the current market crisis. Nationally based financial operations are shrinking and internationally oriented operations are taking their place. Globalization usually implies decentralization. But while the international network of financial centers is indeed expanding, a leaner system dominated by a handful of strategic cities is evolving. As financial operations disperse around the world, only a few cities will have the resources to be dominant. First among them are London and New York, with their enormous concentrations of resources and talent. These two will conduct the most critical and complex financial operations of the future. A secondary network of smaller economic capitals will be headed by Frankfurt, boosted by Europe’s economic and monetary union. The ultimate status of battered Hong Kong and Tokyo remains murky as markets wait to see what will be left in the wake of the Asian crisis. Although Singapore and Sydney are strengthening their positions, it is difficult to imagine them replacing Tokyo’s resources and Hong Kong’s expertise.

The emerging financial system will sharply differ from earlier versions, which were strings of closed domestic markets with a few scattered global centers such as the offshore markets and Swiss international banking. Traditionally, each national center duplicated all financial functions for its own economy, and collaboration between national markets was crude and rare. Today, however, cooperation is on the rise. Leading financial services firms are now setting up operations across the globe while traditional national centers are becoming home to foreign firms with global operations. Leading cities like London and New York are executing complex operations for firms and governments from myriad countries, packaging capital in innovative ways while working with secondary cities through affiliates and direct exports of financial services. In contrast, other cities in the global network are playing “gateway” roles, such as monitoring capital flows or issuing bonds. One example is Argentina’s $i billion government bond in November, the largest emerging market bond since the market turmoil last August. Although the bond was issued in Argentina, its lead managers were J. P Morgan and Germany’s Deutsche Bank and most of its buyers were U.S. institutional investors.

Secrets of Success

What turns an ordinary city into a global financial center? Although many factors can boost a city’s status, two elements stand out. The first is national consolidation, which favors cities with major institutional equity holdings. In the past, a nation’s financial activity was often scattered among several major cities; today, most countries have one dominant national center of operations. Today, a city lacking a major stock exchange can participate in the global market if it has banks and investment houses holding significant amounts of equity. Second, new financial capitals have appeared in emerging markets that have taken the plunge into market liberalization-a trend that will continue despite the current financial turmoil.

The importance of national consolidation can be seen around the world. New York’s concentration of investment banks and dominance of the U.S. stock market have now left its U.S. rivals far behind. Sydney and Toronto have gained on Melbourne and Montreal, respectively. Sao Paulo has overtaken Rio de Janeiro, while Bombay has outstripped New Delhi and Calcutta. Paris today controls more of the financial sector than it did ten years ago, relegating once-important stock markets like Lyon to provincial status. In 1997 Frankfurt’s market capitalization was five times greater than all other regional markets in Germany combined; in 1992 it was only twice as large. And Zurich commands the Swiss market, leaving Geneva and Basel behind. In all these cases, this pattern is spurred by rapid growth in the leading cities rather than decay in secondary cities, many of which are also growing.

Internationally, concentration looms large as well. By the end of 1997, 25 cities controlled 83 percent of the world’s equities under institutional management and accounted for roughly half of global market capitalization (around $20.9 trillion). Six or seven cities head this league; London, New York, and Tokyo combined hold a third of the world’s institutionally managed equities and account for 58 percent of the global foreign exchange market. The distribution of institutional equity holdings is also important, for a financial center is more than just the sum of its exchanges. Although London and New York still lead, the list of financial leaders also includes several cities without a strong stock market presence, such as Boston, Philadelphia, San Francisco, Geneva, Edinburgh, and Stockholm.

Last, the number of cities joining the global financial club is growing sharply as countries deregulate their economies. Sao Paulo and Bombay emerged as players in international capital markets only after Brazil and India partially liberalized their own markets. When such cities join the financial major leagues, they become bridges to international business as foreign financial, accounting, and law firms enter their markets to handle the new cross-border operations. Although these newcomers may not budge global leaders from their market dominance, the overall volume of financial activity invariably rises.

Location, Location, Location

Location still matters. Even as digitalization, decentralization, and denationalization radically change the way business is done, one still needs a central base, not just an address, to run financial operations. Both markets and firms need massive resources and highly concentrated advanced technology to function-two factors that favor a geographical center. The complex nature of information requires highly educated personnel to analyze data and make that analysis available to other market players. In turn, those participants can gauge information and understand risk better when they have immediate contact with one another. Executing deals requires strategic combinations of top talent in law, accounting, and forecasting. For these reasons, cities rather than computers will still coordinate business and finance, and the two world leaders, New York and London, will continue to tower above the rest.

True, powerful trends of decentralization are underway. People, goods, and services move with growing ease; many corporate services and even markets are dispersing operations around the globe. In the 1980s, for example, all basic wholesale foreign exchange operations were in London; today they are scattered in Tokyo, Singapore, Hong Kong, Zurich, Frankfurt, and Paris. Indeed, the entire network of financial centers has grown markedly in the past decade. But even this trend is overshadowed by a more powerful wave of consolidation. The more a firm disperses operations, the more complex and centralized its top-level management operations become. For instance, electronic information networks like Reuters 2000 and Electronic Brokerage Systems (EBS) now handle about 6o percent of London’s foreign exchange market. New telecommunications technology also makes central coordination for firms and markets easier. Many markets need a base for their operations and executive decision-making, given the complications of operating a widely decentralized business. Executing such tasks requires top talent and specialized services in technology, accounting, law, and economic forecasting. Even global electronic markets such as NASDAQ and E*Trade rely on traders and banks located in a major city like New York.

Sophisticated information needs also keep location important. There are two basic types of information, the first being simple data: At what level did Wall Street close? Did Argentina complete the public-sector sale of its water utility? Has Japan declared a major bank insolvent? Access to this kind of data is now global and immediate, thanks to the digital revolution. An investor in the Colorado Rockies can get the same kind of straightforward news that a New York trader can. But on another level lies a more complex type of information: analysis and interpretation, or the intelligence that results from concentrating market players and resources all in one city.

In principle, technical infrastructure for global communication, or connectivity, can be reproduced anywhere. But the social infrastructure for global connectivity points to the importance of location. Singapore, for example, has technology on a par with Hong Kong but not as many sophisticated market players in the global information loop. When investors cannot find more complex forms of information for major international deals in their existing databases, they can get it by exchanging data and ideas among talented, informed people. Location also counts for risk management, or how banks assess the potential risk of investments and holdings. Given that many major trading losses over the last decade have involved human error or fraud, the quality of risk management depends heavily on a firm’s top people rather than on mere technology, like electronic surveillance. The fall of Barings Bank at the hands of a single trader and the enormous losses from hedge fund speculation at the Union Bank of Switzerland last autumn are two classic examples. Market players now see consolidating risk management operations in one site as more effective than keeping them separate.

Hot Fusion

What other trends are shaping the new financial capitals today? Merger mania-driven by the growing thirst for greater resources-is driving firms and markets into cross-border alliances unthinkable just a few years ago. Market concentration among the top 10 of the So largest financial services firms has roughly doubled from 1992 to 1997, and new kinds of mergers keep cropping up. Swiss Bank fused with Union Bank of Switzerland in 1997 to form the world’s biggest financial institution, holding combined assets of $638 billion. Just four months later, that was topped by the Citibank-Travelers Group merger, valued at $698 billion. But even that record was dashed in November, when Deutsche Bank acquired Bankers Trust, combining assets of around $840 billion. Mid-sized firms could find it difficult to survive in a global market dominated by megagroups such as Merrill Lynch, Morgan Stanley Dean Witter, and Goldman Sachs. Mergers of accounting firms, law practices, and insurance brokers are also on the rise all enterprises that can provide global services. Analysts foresee a system dominated by a few international investment banks and about 25 major fund managers, along with a consolidated telecommunications industry offering them services spanning the globe.

Electronic networks too are testing the merger waters. Perhaps most spectacular was the announcement last summer that the London Stock Exchange and Frankfurt’s Deutsche Borse were tying the knot to attract the top 300 shares from all over Europe and form a blue-chip European exchange. Feeling snubbed, Paris first reacted by proposing that major European exchanges create an alternative alliance. Then Madrid, Milan, Amsterdam, and Helsinki indicated interest in joining London and Frankfurt, and Paris decided its best option would be to jump aboard also rather than try to start up its own network. Elsewhere, the Chicago Board of Trade is now loosely linked to Frankfurt’s Eurex, the largest European electronic futures exchange, and the Chicago Mercantile Exchange has hooked up with the Paris futures exchange, the Matif. The New York Stock Exchange is considering partnerships with exchanges in Canada and Latin America and is already talking with the Paris Bourse. NASDAQ’S parent is having similar discussions with Frankfurt and London.

Global Bonding

Globalization often implies abandoning national ties and embracing supranational alliances. In international finance, this is more than a buzzword; it is a reality. One example is the relationship between the “big three”-London, New York, and Tokyo. Market participants often paint a picture of ruthless competition, which is only partly correct. In truth, the relationship is more complex. During the wave of deregulation in the 1980s, the big three already had some cooperative division of labor that continues today with increasing specialization. Despite all the talk of bitter competition in the roaring 1980s, a truly global market was emerging that was circulating capital through the leading financial centers before selling it repackaged at home. Since this trend intensified in the 1990s, cross-border strategic alliances have been multiplying between both firms and markets. Competition coexists with strategic collaboration and hierarchy. The eurozone will further reinforce this trend by eliminating the various financial functions, notably the foreign exchange trade, that bolstered the existence of an “international” financial center in each member country. It will also consolidate the government bond market, establish a single currency market with one short-term base interest rate, and eventually create a single equities market. In the future, national stock markets could coexist alongside a blue-chip pan-European stock exchange. In the bond market, meanwhile, the creditworthiness of the borrower will matter, not the national currency.

Major U.S. and European investment banks have set up specialized offices in London to handle their global business. Even French banks have set up some operations in London, inconceivable even a few years ago and still downplayed in national rhetoric. Nationality simply means less than it did even a decade ago. Global financial products are accessible in national markets and national investors can operate in global markets. Investment banks used to split up their analyst teams by country to cover a national market; now they tend to do it by industrial sector across all major countries.

Globalization has helped partly denationalize asset ownership and market regulation in many countries. Some caution is necessary, however, when assessing how far this trend can go. In many ways, it is only a partial step, albeit a necessary one for globalizing business practices. The modern financial system’s sophistication stems from this limited approach: many firms and markets are “global” only when it comes to strategic institutional areas. National economies and consumer markets can stay basically unaltered. China is a good example. It adopted international accounting rules in 1993 to engage in global transactions. How much of its domestic economy did it have to change? Not much. When China launched its 100-year bond in 1996, it aimed at selling it not in Shanghai or even Hong Kong, but in New York; rather than going through the U.S. government, it went through J. P. Morgan. At the same time, China left major domestic reforms unaddressed. In a similar vein, Japanese firms operating overseas adopted international standards long before Japan’s government considered requiring them to be listed on the New York Stock Exchange-an example of “strategic denationalization” that I have discussed in my book Losing Control?

Acquisitions of firms and property in crisis-ridden Asia will further intensify denationalization. In the year since the crisis exploded, Lehman Brothers bought Thai residential mortgages worth half a billion dollars at a 53 percent discount, the first auction conducted by the Thai government’s Financial Restructuring Authority and a mere fraction of a $21 billion national fire sale of financial-company assets. Lehman Brothers has also acquired the Thai operations of the failed Hong Kong investment bank Peregrine. The Asian financial crisis has thus partially loosened national control over key sectors of economies that had never been open in the past even while absorbing massive inflows of foreign investment.

Capital Capitals

London is the preeminent city for global finance today, in good part due to the numerous international firms that have located key operations and resources in the City, London’s financial district. It leads the world in institutional equity management, holding over $1.8 trillion in assets at the end of 1997–a 48 percent increase from Xi–2 trillion in 1996, boosted by the 25 percent stock market rise in the last two years (before the all-time high of July 1998 and the subsequent sharp fall). The mighty capital of the eurozone, Frankfurt, ranks a mere ninth in institutional equity holdings. London’s stock market capitalization at November 1998 stood at over $2.1 trillion, topping those of Frankfurt and Paris combined. London, together with another eurozone outsider, Zurich, accounts for over half of all market capitalization in Europe. It is arguably the world’s biggest net exporter of financial services, with a surplus of $8.1 billion in 1997. It also leads in international bank lending, consulting on cross-border mergers and acquisitions, and trading and issuing international bonds. Finally, London is the leading global foreign exchange center, with a 40 percent market share, far ahead of New York.

What London lacks is Wall Street’s brilliant financial engineering and Frankfurt’s location as the capital of the eurozone. It does not hold Japan’s enormous savings accounts or Hong Kong’s strategic advantage as a link between global capital markets and China. Much of London’s prominence is due instead to the leading U.S. and European investment firms that have located key operations there. U.S. firms in London are using the City on expectations that eurozone equity markets will double, if not triple, over the next decade-an addition of over $10 trillion by 200. Hence, major U. S. names like Merrill Lynch, Morgan Stanley Dean Witter, Citigroup, and Mellon Bank are slashing their staffs around the world but continuing to build up in London and acquire U.K. investment firms.

London’s unique denationalized platform for global operations gives it its competitive advantage. One important factor is its flexible regulation policy, which basically leaves wholesale financial traders alone and concentrates only on retail finance to protect consumers. Its legal and accounting systems are and will remain the international standard. Its regulatory framework is far more flexible for wholesale finance than the codified systems of continental Europe. While European banks arranged over half of all cross-border lending in 1997, London (and to a lesser extent New York, Hong Kong, and Singapore) handled the value-added activities and syndication. Its status as an offshore market has also reinforced its internationalization; the electronic network between the London Stock Exchange and Frankfurt’s Deutsche Borse will only reinforce this development, as will the emergence of a pan-European exchange. And London’s long tradition of empire has left it with bridges throughout the world. Together, these features will make London the ultimate deregulated international center for finance, business, and non-European dealings in the euro-and not, as many commentators assert, a loser in the new eurozone.

New York is the only other city poised for that kind of supremacy. New York dominates in another way by offering market innovations and new financial products. Wall Street-still the Silicon Valley of finance-has made U.S. investment firms leaders in the global market. The strength of U.S. banks and equity markets, and the size and quality of its domestic capital markets, will also continue to power New York. The United States produces only a fifth of global gross product but almost half the total value of the world’s equity markets. Furthermore, New York’s top investment banks often operate through branches abroad and thus feed the strength of other centers. The top five firms handling mergers and acquisitions in Europe in 1997 were from the United States. (The first European firm on the list, Lazard Freres, ranked only sixth.) Among the 5o biggest financial services firms in the world in 1997, the top ten handled 72 percent of all transactions; eight of these firms were American.

New York is by far the biggest domestic capital market. The New York Stock Exchange is the world’s largest, listing about 3,000 companies, albeit for an overwhelmingly domestic market. Even this is changing, however. The NYSE now has well over 300 foreign firms listed, thanks to the recent rash of international initial public offerings. In contrast, the Tokyo stock exchange is still losing foreign firms, even after the government eased listing requirements and costs. The NYSE will also begin trading in decimals rather than fractions over the next few years to move closer to international standards. Finally, the U.S. Securities Exchange Commission has also lowered some barriers to foreigners and approved new international accounting standards for all issuers regardless of national origin.

Discredited in Asia

The Asian crisis has cast a long shadow on the region’s preeminent financial centers, Hong Kong and Tokyo. Despite Hong Kong’s unique role as a bridge between the world economy and China and its abundance of specialized services, it has yet to overcome the shocks of financial turbulence. In 1997, it lost 23 percent of the value of assets under its management. Stocks and real estate have tumbled by half in the past year and may fall further, even though they recovered a quarter of their value last autumn. This collapse has been led by a recent slump in property prices, since property-linked companies dominate the stock index. To stem these losses, the government placed around $3 billion in foreign reserves in August into stock purchases-to no avail. This failure made clear that no government can thwart through intervention a sustained attack on its markets. Combined debt has reached 150 percent of gross domestic product, one of Asia’s highest debt ratios. Stores all over Hong Kong are going bankrupt, with the best ones bought up by foreign firms at fire-sale prices.

Although the outlook for Tokyo is not much brighter, recent steps toward deregulation could put it back on track as the financial powerhouse in Asia that it was in the 1980s. This time around, deregulation will see more of Japan’s assets and business falling under international management. This includes the $lo trillion in bonds, savings, and pension schemes held by Japanese citizens planning for retirement.

The global capital market simply cannot bypass such enormous resources. In addition, the collapse in domestic prices and the yen has made Japanese firms and real estate attractive targets for foreign investors. Merrill Lynch has already bought 30 branches of Yamaichi Securities, while Societe Generale is acquiring 80 percent of Yamaichi International Capital Management. Citigroup has become the biggest shareholder of Nikko, Tokyo’s third largest brokerage, and Toho Mutual Insurance recently announced a joint venture with G.E. Capital. Foreign investors are also eyeing valuable property in the Ginza, Tokyo’s high-priced shopping and business district-an ironic twist on Mitsubishi’s acquisition of New York’s Rockefeller Center a decade ago.

Nevertheless, Tokyo still lacks the right combination of resources for producing and exporting sophisticated financial services. In this regard, the city functions as a sort of plantation economy. It produces a raw commodity-money-but lets London and New York process it. In the late 1980s, it seemed like Tokyo was ascending toward global financial status. Top investment banks and brokerages set up shop in Japan, and Tokyo looked as if it could surpass Hong Kong as a specialized, state-of-the-art financial center. The bursting of the real estate bubble ended Tokyo’s rise, but its role would have been limited even without the crisis. As long as Tokyo refused to accept international accounting and financial reporting norms, its potential was always restricted. Tokyo stayed too Japanese. This is only now changing because the financial crisis is letting foreign firms enter Asian markets on an unprecedented scale, bringing Tokyo the sophisticated denationalized expertise necessary for world status. This trend was already illustrated in December when Japan’s largest consumer loan company, Takefuji, listed on the Tokyo stock exchange with Warburg Dillon Reed as a lead underwrite-the first time a Japanese company ever used a foreign broker to list in Tokyo.

The Perils of Prosperity

In the end, what does the transformation of the international financial system add up to? The network of cities joining the global financial market is growing and feeding the strength of the leaders, London and New York. Trading volumes are rising but have not significantly changed the overall distribution of market share. And top-level functions are consolidating in cities that are transcending their national attachments. Clearly, the global financial system is here to stay. But by its very design-based on connectivity, mobility, and speed-it will continue to be enormously volatile. And therein lies the rub: For emerging markets, hot capital flows may not be the most prudent and steady way to finance development. We therefore need to understand better what it means to install global financial institutions into national markets and replace domestic plans with an international corporate agenda. Countries will further facilitate capital flows by privatizing assets, abolishing rigid national controls, and standardizing operations to international norms. All of these measures will reinforce the existing network, make it more transparent, and let more new players join the game. Although markets will continue to thrive on volatility, they must draw on the unique strengths of the leading cities and their second-tier partners to reduce the pain of future turbulence. In this way, emerging markets’ piece of the global financial pie can amount to more than just a few crumbs. And while London and New York will continue to lead, the wealth they manage can spread from the few to the many.