Hamish McRae: Lord Turner's tax is a trauma too far for our biggest foreign earner

Economic Life

Well, Lord Turner certainly knows how to set the cat among the pigeons, doesn't he? The new head of the Financial Services Authority celebrates his appointment by rubbishing the industry he is supposed to regulating. Some banking activities are "socially useless", there ought to be an international tax on financial trading to cut bank profits, and so on.

There is a short response to all this, which is to say that (a) you can see why the FSA is going to be abolished in a few months' time when the Tories get in, and (b) an international tax is for the birds, for the world's largest banks are now the Chinese ones and the main sovereign wealth funds are in the Middle East. Neither are hardly likely to listen to a British political appointee on the matter.

There is a longer response, which is to think of the role of the financial services industry in the future, the way it will be changed by the events of the past year, and the implications for our economy and indeed the global one. The comments were part of a wider panel discussion carried in Prospect magazine, which delved into these areas in a generally thoughtful manner. What Adair Turner was saying is much more nuanced than the soundbites that have grabbed the headlines would suggest.

Obviously there is going to be a fair amount of "what is to be done now?" in any discussion of the future of finance after the trauma of the past two years, but my own preference would be more to look at the long-term changes that have taken place within finance in the past and to see how what is happening now fits into the industry's history.

The basic point is that there have been periodic banking and financial scares in the past and there will doubtless be more in the future. After each scare there has been a period of increased regulation, and we are going to have that now. That is obvious. Less obvious is the long-term oscillation that has taken place between banking intermediation and securities market intermediation, and I suspect that we are heading into a period where banks will lose ground towards securities markets.

Go back to the 19th century and the principal way funds were raised in most of the world was by issuing securities. Banks came over the years to take on a larger role in both Germany and Japan, but mostly by default: the companies they had lent to got into trouble and the banks got shares instead. In the UK in the 1950s banks only lent to companies on overdraft, and only for their working capital needs. The medium-term syndicated loan had yet to be invented. Then over the past 30 years banks have gradually taken on a larger role, and during this century that role expanded dramatically, with catastrophic results.

This last phase of growth was made possible by securitisation, the parcelling up of loans and then the selling on of these products. The banks thought that by securitising loans they were reducing their risk. If these had been genuine securities in the 19th century sense they might have been proved right, but the products were too complicated for the end-buyers to understand, and many of those end-buyers were the banks themselves. So instead of spreading risk, the banks concentrated it.

The result will be constraints on the banks in the form of higher capital requirements and so on, and the result of that will be that banks will lose market share to "real" securities markets, and to some extent finance will shrink.

The latter is already happening. Let me give you two examples. A large company I spoke with recently was acting as "banker" to its suppliers and customers. It was cash-rich and found it was getting dreadful returns on its funds with the banks or on the money markets. It offered to pay suppliers earlier and extend credit to customers for longer than the usual terms, adjusting the prices accordingly. Result: it got the equivalent of a higher return on its spare cash, and its business partners were able to borrow at lower rates than they could from their banks.

The other example of disintermediation (horrid word, I know) is nearer home. Parents or grandparents are getting paltry interest on their cash, while their children and grandchildren are finding it hard to get a mortgage. So the "cash rich" members lend to the "cash poor" ones on whatever terms are mutually agreed. Again the bank is bypassed. Websites are springing up to match borrowers and lenders, often within families or communities, and it will be interesting to see how far this develops.

There are many other parallel developments, including the revival of the corporate bond market, and the issue is how far this trend will run. If banks remain risk-averse (or are made to remain risk-averse) for a generation, then the financial markets will develop other ways of matching would-be depositors and would-be borrowers. I suspect we are still in the very early stages of this trend, and it will move in all sorts of ways that at the moment are not predictable.

It will not, however, be particularly good news for London or the UK economy. Most people don't realise quite how important the financial sector is to the economy. It is not just that finance pays 40 per cent of corporation tax, or at least it did until last year. It also enables the country to balance the books. Data from the Balance of Payments 2009 Pink Book, which came out a few days ago, shows we have a huge and growing surplus on trade in financial services. The industry is by far our biggest foreign earner. Banking is by far the largest element in that surplus, much bigger, for example, than fund management.

You have to see Adair Turner's comments in this context. It is not his job to promote the industry that he regulates, and he was right to make that clear. But I cannot see a German public official saying that he would be happy if the country had a much smaller car industry or an American one being comfortable with the country losing market share in aircraft manufacturing. And I cannot see either calling for a new international tax on car companies' or airframe manufacturers' profits. A global "Tobin" tax on foreign exchange trading, so called after the suggestion by the Nobel Prize-winning economist? Er, where is the world's largest foreign exchange market? Yup, London. You can see why the Treasury was apparently less than thrilled by the remarks.

It may be that we just have to go through the pain. We may have to lose market share in finance and lose export income as a result. But it would be a shame to lose more than we need to because of policies designed to disadvantage our biggest export industry.

London's financial services are adaptable and will work out ways of meeting the demand for services, but I fear the lessons of the 1970s will have to be relearnt. True, the economic situation is not as bad as in the 1970s, but the fiscal situation is worse. A lot is riding on the next government.