Corporate Governance Failures: The Role of Institutional Investors in the Global Financial Crisis

4 Chasing Alpha: An Ideological Explanation of the Catastrophic Failure in the U.K.'s Financial Services Industry

C h a p t e r 4 Chasing Alpha: An Ideological Explanation of the Catastrophic Failure in the U.K.'s Financial Services Industry Philip Augar Introduction ‘‘Alpha’’ is shorthand in the City of London for supercharged profit, and ‘‘chasing alpha’’ is what Britain’s bankers, investors, and corporate chief executives did in the last two decades of the twentieth century and the opening years of this millennium, culminating between 2003 and 2007 in an orgy of leverage and reckless growth plans. But to most participants and observers, the years 1997–2007 seemed to show that chasing alpha worked. By the year 2007, the U.K. had come to play a pivotal role in the global financial services industry. The financial districts of London—the Square Mile around the Bank of England in Threadneedle Street, the soaring towers of Canary Wharf in Docklands, and glitzy hedgefundland in St. James’s and Mayfair, collectively known as the ‘‘the City’’—claimed to rival New York as the world’s international financial services capital. New York’s city fathers were sufficiently concerned by the City’s rapidly increasing market share that in 2007 they commissioned the consulting firm McKinsey to address the issue.1 The statistics were indeed impressive. London’s share of the global over-the-counter derivatives market exceeded 40 percent, over 20 percent of the world’s hedge fund 84 Philip Augar assets were managed in London, and Europe, principally the City, accounted for 63 percent of global IPOs in 2006. By this time, Europe, at one time an afterthought for the big American investment banks, contributed nearly half of their total revenues.2 The City’s success helped to transform Britain’s ailing manufacturing economy into a modern knowledge-led economy. Financial services’ share of national output rose from 5 percent in 2001 to 8 percent in 2007, the industry contributed a trade surplus of nearly £40 billion, provided more than one million jobs, and accounted for almost 14 percent of the total tax collected by Her Majesty’s Revenue and Customs.3 Much of this success had been achieved during Gordon Brown’s record-breaking time as chancellor of the exchequer between 1997 and 2007 and he regarded the City as a role model for the rest of the country, once telling an audience of bankers: ‘‘What you have achieved for the financial services sector we, as a country, now aspire to achieve for the whole of the British economy.’’4 The Turnaround It had been a sudden turnaround. London’s mercantile traditions went back to the fifteenth century but for many years the City was a closed shop, clubby and inward looking and not especially hard working. Entrepreneurialism was strongest in the eponymous merchant banks founded by European émigré families such as the Rothschilds and the Warburgs, but their development was hindered by banking rules and regulations that restricted their involvement in capital markets. Between the end of the Second World War and 1979, as the Labour and Conservative parties took turns holding power, the City lumbered on, distrusted by the former, left to its own devices by the latter, and not regarded as critical to national prosperity by either party. Things changed for Britain and the City in 1979 when Margaret Thatcher ’s Conservatives won power. Vigorous free market economics replaced a postwar muddle as the guiding ideology. Industry was deregulated and competition policy was relaxed, opening the way for industrial restructuring and a wave of mergers and acquisitions. Legislation was introduced to break the power of the trade unions, which for three decades had held the country in their palm. One of the first acts of the Thatcher government was to abolish foreign exchange controls, removing a forty-year-old constraint Chasing Alpha 85 that had discouraged British investors and industrialists from investing abroad. Publicly owned utilities such as the gas, electricity, and telecommunications industries were deregulated and privatized, exposing strategic parts of the economy to market forces for the first time. Deregulation was extended to the financial services industry itself through the Big Bang reforms of 1986, which opened the stock exchange to competition and introduced the American model of integrated investment banking. U.S. banks and investment banks moved into London, using their superior managerial skills, more rigorous work ethic, and the superprofits earned on Wall Street to squeeze out the British competition. Between 1986 and...