When economic historian Charles Kindleberger charted the rise of financial centers around the world in 1973, he doubted London could take the top spot in Europe's growing union of states: "Sterling is too weak, and British savings too little." Instead, after assessing various cities' economies of scale and corporate pulling power, he plumped for Brussels.
He was clearly betting on the wrong horse, but Kindleberger's treatise should still be top of European regulators' reading list on the eve of a potentially messy end to decades of unfettered free trade with Britain.
His insights into the forces that make or break a financial center resonate in post-Brexit Europe. Over-centralization carries big risks, bringing what he called "diseconomies of scale," such as information bottlenecks, spiraling overheads and interference by politicians. His work is a challenge to those who scoff at the idea that London could ever face any serious competition.
The U.K. financial capital arguably became too concentrated for its own good. The 2016 Brexit vote showed euro-zone officials were right to warn that it was risky to have a third of all EU capital markets activity and 90% of euro-denominated derivatives clearing in one place.
Back in the 1970s when Kindleberger was writing, the City looked more like a speculative bubble than a real contender, with U.S. banks using London as a revolving door for U.S. dollar-denominated deposits held overseas called eurodollars. Nobody was waxing lyrical about the City's talent pool, or superior legal system, as so many do today. Its attraction as a conduit for European cash only really took off after the 1980s, helped by light-touch regulation, political stability and its membership in the EU single market.
Those advantages are more vulnerable today than they've ever been. With the post-Brexit transition period set to end on Dec. 31, bringing an end to the U.K.'s frictionless market access to the EU, euro-area hubs are dangling the carrot of tax breaks and regulators are waving the stick of forced relocations. Financial firms operating in the U.K. have already shifted about 7,500 staff and more than 1.2 trillion pounds ($1.6 trillion) of assets to the EU.
This isn't an exodus, and nobody's saying that Paris or Frankfurt will suddenly replace London. But we're in a decentralizing phase where many centers can happily coexist. Dublin and Luxembourg's fund-management hubs have wooed insurers. Amsterdam has attracted trading firms with its fast fiber network. JPMorgan Chase & Co. is moving $230 billion in assets to Germany. And Europlace, an agency promoting Paris as a financial center, estimates 4,000 direct jobs have already been announced in the French capital.
Like the movie "Field of Dreams," Europeans are also talking up deeper capital markets integration as a way to unlock trillions in household wealth: If the EU builds it, banks will come.
Yet this is the part where Kindleberger's analysis should send a chill down the spine of continental officials.
The pressure to decentralize also has big downsides: It tends to trigger resistance. We're seeing banks drag their feet on relocations, with Covid-19 a handy excuse to call for more time as they balk at the cost of creating new cross-border entities.
Obstacles are also apparent in the $74 trillion fight over euro clearing, with Paris and Frankfurt initially at the vanguard of efforts to force the likes of London Stock Exchange Group Plc's LCH to repatriate activities to the continent. The effort has faced persistent pushback from banks that fear it would mean paying more for a high-volume, low-margin business.
It has exposed confusion within Europe, too. The European Central Bank wants more relocation, markets watchdog ESMA wants more power to oversee clearinghouses based outside the EU, and national supervisors want to avoid losing more power to EU bodies. These tensions, combined with a shift in priorities since Covid-19, have convinced Brussels to let continental firms access London's dominant clearing-houses as they currently do until mid-2022.
While a genuine continental rival to the City would be a good thing, its emergence is hindered by infighting and sclerosis impeding deeper market integration — potential problems spotted by Kindleberger decades ago. Regulatory turf wars and embarrassing financial scandals point to the scale of the task ahead. A capital markets union has been all talk and no action for many years.
If Europe won't get serious about integration, wrote Kindleberger, "there will be no single European financial center."
The EU should heed these warnings from the past. It needs to decide the new terms of trade with a still-dominant London. Some kind of regulatory equivalence would be ideal, allowing for time to develop home-grown hubs while avoiding more market disruption than is necessary. The bloc then needs to overhaul and strengthen EU financial regulation. Given the dire health of a lot of European banks — State Street's Marija Veitmane described them as "uninvestable" this week — a future capital markets union should go hand in hand with a full banking union and cross-border bank mergers.
The bottom line is that the best-laid plans can go awry. Governments can't simply will a financial center into being. Accidents — and crises — can happen. If the EU miscalculates, it won't only be London that wins, but far-flung rivals in the U.S. and Asia. Brussels may have to wait a little longer.
Lionel Laurent is a Bloomberg Opinion columnist covering the European Union and France. He worked previously at Reuters and Forbes.
Disclaimer: This article first appeared on bloomberg.com, and is published by special syndication arrangement.