The British financial system is the single most important reason for our economic decline. Yet change is unlikely, says Will Hutton.
Is the City good for Britain? And, in particular, are takeovers good for Britain? Yes, say the advocates of keeping managers on their toes. No, say those who believe that this year's earnings per share performance is little guide to a company's long-term future. The statistics fly; angry words are exchanged. Does anybody really believe that Hanson will benefit ICI? Of course not, but then, on the other hand, ICI has not done very well of late. Maybe, just maybe, it needed a shake-up.
Round in circles we go. There might be an inquiry. Perhaps the Confederation of British Industry (CBI) will investigate short-termism. After all, 15 years ago former Prime Minister Harold Wilson chaired a committee on the funding of financial institutions. A Chancellor might call for an inquiry into the banks' lending policies. There will be recommendations, shortcomings identified, calls for a new code of conduct - but nothing in its essentials will have been challenged or changed. The bankers, the venture capitalists and the investing institutions will have argued their corner, insisting that they are responding to market forces and that no other course of conduct is open to them. There is some huffing and puffing - and there the matter rests.
The current debate over takeovers is a classic of its type, echoing similar complaints and preoccupations over the past century, which lapse eventually into temporary silence before the next round of financial excesses prompts another orgy of ineffectual breast-beating. For the critics, in focusing on one issue, always miss the point: the British financial system in its totality is the problem. It is the single most important reason for our economic decline. Home in on any one aspect and you will be bested by the argument that that is how the market works; you need to take on the lot. It is only by comprehending all of the inter-relationships that you can begin to understand the degree of economic cancer that British finance brings in its train; unintended in many cases, perhaps, but nonetheless malevolent.
It is in the personal collateral, including their houses, demanded by banks of small businessmen, thus contravening the spirit of limited liability. It is the demand by venture capitalists that the companies that they back float themselves as soon as possible on the stock market, so providing their venture capital backers with "exit" and a capital gain - whether they are ready for the rigours of a public quotation or not.
It is a company in crisis being closed or heavily rationalised at the instigation of its bankers rather than being nursed back to health. It is the reliance on overdraft finance which keeps borrowers on a short leash, and the general provision of short-term, highly secured loans which require hurdle rates of at least 25% to deliver the cash paybacks to service the loan. It is the concentration of decision making in London by banks and investment institutions alike, so that in the case of banks, relatively small requests for loans have to be referred to head office.
It is that the UK's largest 115 companies pay at least twice and sometimes three times as much out of their profits in dividends compared with their counterparts in West Germany. It is the risk-averse corporate strategies prosecuted by companies anxious to maintain profit and dividend growth. It is the accent on deal-making against organic growth, with an accounting system that is blind to whether profits are made from deals or solid added value.
And above all, it is the general context in which small, medium and big companies do business. What drives business strategies and internal organisation alike is not the needs of the product market but the capital markets. For example, internal accounting systems in continental and Japanese companies are designed to signal that the rewards are for building market share or growing a company. In Britain the systems are about cost minimisation, risk aversion and delivery of sound results for external shareholders.
The bias reaches its apogee in the companies battling for their independence after a hostile stake has been taken - and in Tootal, Plessey, Rowntree Mackintosh, Imperial or any other of the host of top companies that have been stalked over the years and which all became palsied into defensiveness as they sought unsuccessfully to stave off their predators. But they are only the obvious one tenth of the iceberg of financially induced destructive corporate behaviour. The submerged nine tenths may be out of sight but the behaviour is similar.
The end result is that Britain has an economy which is bedevilled by a persistent bias against investment where the returns may be uncertain, and towards investment where the returns are sound and apparently predictable.
So it was during the 1980s that we saw the results most completely. Business investment certainly rose to record proportions of gross domestic product - but it was not investment in areas of risk. Financial services, property, communications, distribution and hotels all saw an explosion of investment interest but they were all sectors protected from international competition and characterised by possessing large quantities of property as collateral. They could support the large amounts of relatively short-term debt which were so willingly furnished. Institutional investors were all too ready cheerleaders in a world that favoured deal-making amid ever rising property values.
What were not popular were those sectors with apparently less predictable income streams; areas where international competition was tough and where long lead times meant that it was hard to assess just how profitable a venture might be. Rolls-Royce was floated, like British Aerospace, upon a stock market ready for the short-term capital gains of privatisation, but soon both companies were languishing on low multiples of earnings as the investment community worried about the vast sums that both companies had to spend on research and development and investment generally.
According to Professor Michael Porder in his book "The Competitive Advantage of Nations", aerospace and jet engines are two of the few remaining areas where Britain retains a critical mass of manufacturing excellence. Ten years in Britain's capital markets and they will be reduced to the same level as our motor, television or shipbuilding industries.
The message is inescapable if we consider how investment in various sectors has grown since 1979: the most vigorous are banking, communications and distribution; the least rapidly growing are motor vehicles, mechanical engineering and mineral oil processing. Furthermore, if we look at the extent to which the output of the varying sectors competes directly with exports or imports - an index of what John Muellbauer and Anthony Murphy, its authors, call tradeability - it seems that the more significant the tradeability, the less the rate of investment - an important reason why we have had a trade deficit even in the middle of an acute recession.
The recent tiny trade surpluses of the past couple of months have only come about as a result of a complete slowdown of economic activity at home and some cheerful export figures. With a pick-up in demand at home, Britain will almost certainly plunge into the red again and stay there.
But behind the differential investment growth lie the preferences and signals sent by our banks and investment institutions - the pension funds and insurance companies. They like to portray themselves as the passive providers of funds, with no influence on the investment priorities of the business community which is driven by market signals. But the point is that those very market signals are frequently the result of a complex chain of causation which originates in the financial system itself.
For example, the prime characteristic of British bank debt is that it is short term. National Westminster Bank shows in the Form 20F documents which it has lodged with the United States Securities and Exchange Commission that between 1985 and 1990 it trebled its UK lending; and of the £31 billion increase, more than half was for loans of less than a year's duration. Meanwhile, Deutsche Bank in 1990 extended more than half of its loans for four years or longer.
Now, the fact that British industry accepts loans on these terms matters, because it limits the kinds of projects that can be financed. The British machine tool industry languishes while that in Germany flourishes, but then German machine tool businesses do not have to generate sufficient cash to service the loan repayments on short-term debt. And this then turns into a self-reinforcing decline: because the machine tool companies are under financial pressure, they cannot order the components for grinding, milling and drilling machines, so manufacturing those components becomes less profitable; the companies cut back and rationalise, so eroding the critical mass of competing businesses which defines a healthy industrial sector.
It also means that companies have to retreat into niche production. Confronted by Japanese and German producers which can price their products to yield cash flow that will service 10-year debt, British producers have to give ground. They produce in relatively protected, high-margin niche sectors which give the sort of returns demanded by the financial community - but they never remain high margin for long. And when the competition attacks, the response is necessarily defensive because at any given price level, competitors are always able to invest more, or to live with the cash flow consequences of underpricing to maintain market share. The returns are made to be poor, which confirms the financial community's judgement that it was right to be cautious and keep loans short term and investment exposure minimal. And on to the next round of de-industrialisation.
The general preference is revealed at moments of crisis. In 1974 both the then British Leyland and Toyo Kogyo, maker of Mazda cars, were reeling after the oil shock. BL, with production of 1.2 million cars a year, was half as large again as Toyo Kogyo and it did not have a product range organised around the gas-guzzling rotary engine. Moreover, while its debts of $365 million exactly equalled shareholders' funds, Toyo Kogyo's were four times as high. Of the two low-margin, indebted car companies, BL's survival seemed more likely.
Nearly two decades later we know how the story ended, but what is instructive is the role of the two companies' respective bankers. The consortium of four British clearers simply refused BL's panic request for a billion-pound credit line. As a result, the National Enterprise Board ended up owning and financing the rationalisation package, complete with a bias towards paying large redundancy payments out of government grants rather than investment.
In Japan, Sumitomo Bank responded by sending in a "crisis task force". Production was cut, pay frozen, dividends slashed and the assets disposed of. A resource plan was devised, involving a huge investment in products and equipment - an investment which Sumitomo financed. The executive vice-president in charge of the operation described his bank's operation as "an army of occupation. Active intervention was unavoidable."
Sumitomo said that it would "stand by the company to the end", and even though the gearing ratios, by British standards, were disastrously high, the bank continued to finance the company using its muscle with other creditors to make sure that they did not foreclose on the whole enterprise. There were layoffs, but in the balance that any company has to strike in a retrenchment between shrinking operations and shifting into more profitable areas, the bias was all towards shifting.
By 1980 Toyo Kogyo had launched five new models and lost 27% of its labour force; by the same year BL had yet to launch one new model, and although between 1974 and 1976 it had made no compulsory redundancies, by 1980 its labour force was two thirds the level of six years earlier. The loss of market share encountered in those years has proved irreversible and today BL is a subsidiary of British Aerospace.
Of course, there were lots of other factors at work, but the central truth is that Sumitomo's approach represents an activism towards its customers that the British clearers would not attempt or even pretend was their role. They do not have the expertise or managerial competence to mount such an operation, and lacking those in-house skills they are duly much more cautious in how they lend. If you cannot act to protect your money, necessarily you lend on stricter terms - and that means loans that are short term, roll over frequently to give the lender the chance of an "out", and are heavily collateralised. Just the sort of loans, in short, that are so debilitating British industry.
But Sumitomo had one advantage which the clearers did not. It held 5% of Toyo Kogyo's equity, which if repeated under British law would mean that as an owner of the company the bank would lose its privileged claim on the company's assets.
But if ownership brings risks and responsibilities, it also brings opportunity and information. Sumitomo was not surprised by Toyo Kogyo's difficulties; it had been watching the company closely for years and it also knew the management it would have to replace. BL's consortium of bankers had no such intimate information - they were outsiders, kept there as much by the company's unwillingness to disclose information as they had the power to disgorge it. Yet it was not always the case.
In the first 75 years of the 19th century British industry enjoyed a relationship with its financial backers as supportive as German and Japanese industry enjoys today. The regional stock markets only traded bonds and companies found their equity investors from networks of local individuals. Banks were locally based and knew their clients intimately. And, of course, with Britain first in the ring, profits tended to be high, so the demands for external capital were not great. But at the end of the 1870s the system began to buckle. Competition from the US and Germany was driving down profits, yet the pace of technical change was accelerating, so demanding new and more expensive investment. Companies began to require more than their local networks could supply, while the risks increased. If local banks and investors were too closely involved in one firm or industry and it went wrong then their fortunes went wrong too. The City of Glasgow Bank collapse in 1878 warned banks everywhere about the risks - they had to get bigger and diversify their lending. And while the Reichsbank in Germany was prepared to buy industrial loans for cash, the Bank of England resisted such close involvement with industry: it would infringe the maxims of sound finance. And that was the next important conclusion: lend less to industry and restrict it to short-term trade credits and acceptances.
The newly formed national commercial banks should be just that - financers of commerce, not investment. That was the job of risk money and the stock market. And so grew up the legendary, late Victorian share promoters, such as Ernest Terah Hooley who in 1896 brought Bovril, Schweppes and Dunlop to the stock market and so overburdened them with dividend payments that they nearly went bankrupt in the process.
Yet while the early British car, chemical and electricity industries suffered all the depredations of British finance - the early electricity utilities, for example, having continually to defer flotations because of bouts of investor nervousness - German industry cruised effortlessly by. Herr Schuster, a member of the board of Dresdner Bank, observed in 1908: "Our banks are largely responsible for the development of the (German) empire, having fostered and built up its industries ... to them more than any other agency may be credited the splendid results thus far realised."
And Herbert Levinstein, Victorian founder of the British dyestuffs industry, wrote: "The application of knowledge requires finance ... the main cost of industrial research is not in the laboratory but in the application to the large scale - who in England is going to find this? In Germany the banks would and did find it. But in England we have always suffered from a lack of educated money."
The voices are a hundred years old but that could be Sir John Clark (formerly of Plessey) or Sir John Harvey-Jones speaking today. Earlier this year Clark savaged City fund managers for their role in the takeover of Plessey in 1989 by GEC and Siemens. Speaking to the House of Commons Trade and Industry Select Committee, he claimed that Plessey's fate had been determined by 35 fund managers "who did not know one end of a shopfloor from another, who had no interest in the company or any knowledge of what it did, who had no interest in the employees of the company. Thirty five people who had one interest and one interest alone: short-term gain. Thus was the fate of a great company sealed."
Clark went on to say that it was "utterly absurd" that ownership of UK companies was largely concentrated among "a handful of institutions", adding: "This cannot be perceived to be in the public interest." Yet when Daimler-Benz came for its flotation in London last autumn, chairman Edzard Reuter said that he saw no special advantage in the Anglo-Saxon system of finance, echoing the comments 80 years earlier. Indeed, he doubted whether he would look for a quote on Wall Street. Regular three-month reporting of profits distracted managers from the task of growing a business.
For behind Daimler-Benz stands Deutsche Bank. And with its £10 billion of capital investment planned over the next five years and £12 billion on research and development, who thinks that British Aerospace is well equipped, in comparison, to fight back? Is an ever changing share register of institutional shareholders and clearing banks, which think that a three-year loan is long term, the best environment in which to respond? Deutsche Bank boasts departments of engineers and scientists ready to appraise new technologies and advise its clients; how many British clearing bankers would understand new wing technology? We know the answer already: too few.
The German system, like the Japanese, depends on confidence between investors, bankers and companies which allows the whole system to hold larger quantities of longer-term debt. Banks not only provide loan finance; they also invest directly and indirectly on behalf of small shareholders. According to one survey, they held 179 seats on the boards of the top 100 German companies, a degree of involvement unheard of in Britain. But then contested takeover is also unknown; bids must be by agreement in a world in which the banks control so many shareholder votes. This allows German companies to pay less in dividends and use more profit for investment; so that the fact that banks lend broadly the same amounts to the top 100 companies in both countries masks the higher investment in Germany that is possible for any given pound of bank loan.
This is illustrated by the strategic German electrical industry, which had a much better investment record than its British counterpart from 1982 to 1988. While the comparable investment performance for industry as a whole was much closer, British industry was still paying out a much higher proportion of its profits in dividends - 31% against 13% for German firms.
Where the German banks are really decisive, as a study by Professor Colin Mayer of the City University Business School shows, is in their lending to small and medium-sized business. Directors do not have to pledge their houses in exchange for loan finance. Instead they sell some equity. And unlike the venture capitalists, the great German commercial banks see this share stake not to be sold but as a token of continuity that will allow them more information over time to further support their lending.
It is a different culture and the gulf is never so obvious as when the British financial system's intellectual defenders come to the rescue of the unfairly accused object of their loyalty. Can it be true, they ask, that British finance has been letting industry down for a century, that a free market has not corrected all of these adverse trends of its own accord?
A good exponent of the thesis is Professor Paul Marsh, of the London Business School, who dismisses the idea that institutional fund managers seek short-term returns and whose willingness to "churn" their portfolios encourages predators to put companies "in play". His position is that markets necessarily are efficient and what critics regard as deleterious behaviour is no more than market processes.
So it is that quarterly profit returns help fund managers to allocate their portfolios more accurately, and if there is short-termism, it originates in industry itself: with managers who job hop with share bonus schemes and investment appraisal techniques that emphasise the short term. All that finance does is reflect the short-termism that industry itself generates. Could the impulse run from finance to industry? Only to the extent that industrial managers think that finance is short term. But that is a mistake, because they misunderstand how an efficient market must perform.
It is, of course, what the philosopher Sir Karl Popper, in a different context, called a non-falsifiable argument. For Paul Marsh, efficient economies are where there are free markets, and as the financial markets are free so they must be efficient. Once in this loop of reasoning there is no getting out except to draw attention to the real world. But even this does not dissolve the theory; it only means that something is wrong with the real world, not the theory.
Yet it is just this sophistry that critics of the financial system have been battling against for the best part of a century. Keynes experienced it in the 1930s, Harold Wilson in the '70s, and there are enough bruised practitioners who have sat on CBI short-termism committees who have their own horror stories to tell. The banks' position is that they accommodate market forces, not determine them; the position of institutional investors is that the buying and selling of shares produces an efficient market. Prices reflect what is going on in the real world and finance has no determining role. Who would not finance a profitable project?
But what is profitable? And how do you create the industrial strength in which companies have the markets in which to produce profitable goods? The argument is circular, and after 100 years of disappointment the message should be getting through.
We need to reform company law and accounting practice. We need to tax short-term capital gains. The Bank of England needs directly to rediscount industrial loans, like development banks do in industrialising countries. We need a tax system that encourages long-term saving to provide the deposit base for long-term loans. We need to break up the big commercial banks into their regional constituents. We need a public investment credit bank that will compete head on and set a new gold standard of industrial banking, just as the Japanese established the Industrial Bank of Japan and the Germans the Kreditanstalt fuer Wiederaufbau. We should encourage the Germans and Japanese to buy one of our clearers and to launch an industrial banking tradition.
We need to transform the banking examinations, and amend the criteria for what is considered sound lending. We must allow banks to take stakes in industry without losing their ability to protect their depositors. We should expect to see more institutional investors and bankers on supervisory boards. We should discourage buying and selling of stock through punitive stamp duty. We should set lower thresholds for shareholdings that trigger bids, and outlaw nominee shareholdings. Companies should be able to develop "golden" shares that protect them from contested takeover, and all bids should have cash alternatives.
The list could go on - but there is no point. Any non-industrial reader alarmed by the shopping list should not worry. Until industry decides that it will openly support such a campaign, the whole exercise is stillborn. And industry will refuse its participation because it is divided and the programme seems too close to that of the Labour Party. The Conservatives, to whom reform should fall, will duck the issue as they have for a century.
It is the sign of a civilisation in decline. Eighteenth century Spain knew that it should enclose agricultural land to boost yields and so prepare for industrialisation, but the nobles were opposed because it would ruin their hunting and horsemanship, upon which imperial martial Spain depended.
Britain knows that it must reform its financial system, but the establishment is opposed because it produces fees and professional careers for its sort of people. That is the bottom line - which is why there will be no change. And decline and relative impoverishment, like that of 18th century Spain, is inevitable.
Where the profits go - Germany v UK
Electrical engineering Industry
industry as a whole
Dividend payout ratio %
Germany 13.2 13.4
UK 25.4 30.9
Distribution ratio %
Germany 5.8 5.9
UK 18.5 21.9
Investment ratio %
Germany 79.6 75.2
UK 56.9 78.0
Dividend payout ratios are gross dividends divided by net profit before payments to shareholders.
Distribution ratios are shown as a percentage of profits. The German figures assume that all firms pay tax. The figures for each country do not necessarily add up to 100%.
Source: "Banks and Securities Markets: Corporate Financing in Germany and the UK" by Colin Mayer and Ian Alexander, Centre for Policy Research.
(Will Hutton is economics editor of The Guardian.)