The scandal emerged in August when the New York State Department of Financial Services accused the “rogue” Standard Chartered of “scheming” for years to skirt US laws when processing US$250 billion worth of transactions on behalf of Iranian clients.

The accusations are the latest in a spate of banking scandals that could undermine London’s role as a global financial hub. Threats to such a critical asset as “the City” serve as a metaphor for the larger troubles the shrinking UK economy confronts in a post-financial-crisis world.

The importance of this for global investors is that the UK comprised about 8% of the MSCI All Country World Index at the end of last month, compared with 14% for the rest of Europe. To put the UK’s challenges into perspective, though, the country is not headed for an IMF bailout as happened in 1976. Record low bond yields show the country is viewed as a haven from the euro crisis. Many of its best companies are world leaders that will prosper, even if hobbled by their homeland’s slow descent.

The banking scandals rank among the UK’s top challenges because they threaten a sector that is the UK’s biggest source of foreign exchange and pays 12% of the country’s tax. Other financial scandals involve proof that the UK’s biggest banks (with foreign help) have rigged widely used benchmarks for years, that UK banks launder money for terrorists and drug lords and that they rip off local customers by mis-selling insurance and improperly selling interest-rate swaps. On top of that, just about every rogue trading arm that torpedoed its parent in recent years was based in London. The list includes the JPMorgan Chase unit that blew US$7 billion, the feral trader who cost UBS US$2 billion and the quant buffs at AIG, Lehman Brothers and Bear Stearns who fatally dabbled in derivatives.

Rogue banks
The rates-fixing scandal broke in June when regulators fined Barclays 290 million pounds (A$440 billion) for fiddling from 2005 to 2009 with the London and Euribor interbank offered rates, the benchmarks for about US$10 trillion in loans and about US$350 trillion in derivatives. The Royal Bank of Scotland and Lloyds Banking face similar accusations that their traders lied on daily surveys about borrowing costs over certain time frames and in different currencies. The Bank of England is tainted because it ignored warnings about the rigging.

Even more explosive, a US Senate investigation in July found that HSBC exposed the US to “a wide array of money laundering, drug trafficking and terrorist-financing risks” by failing to check about US$15 billion (A$14.5 billion) sourced from Mexico, Russia and other money-laundering blackspots from 2006 to 2009. In August, came the accusations that Standard Chartered left the US “vulnerable to terrorists, weapons dealers, drug kingpins and corrupt regimes”. The Royal Bank of Scotland is being investigated for infringing sanctions against Iran.

British banks have a record of violating US laws. In 2010, Barclays paid US$298 to settle claims it dealt with banks from countries under US sanctions such as Cuba, Iran and Libya. A year earlier, Lloyds paid US$350 million to settle claims over dealing with Iranian banks.

These scandals show that the gentle regulation that UK authorities pursued to promote London as a global financial centre has backfired. The government was forced to nationalise or prop up four of the UK’s nine largest banks during the financial chaos triggered by the recklessness it allowed. The wrongdoing threatens London’s role as the world’s forex hub, a global lending headquarters and a derivatives hot spot.

UK politicians are under pressure to toughen regulations on banks, which already confront sluggish earnings, spiralling bad loans and higher funding costs. Stricter rules may spook some of the 250 foreign banks based in London for they will make the City a costlier and more frustrating base. The scandals make it harder for London to ward off European Commission attempts to regulate hedge funds, most of which are based in London, or to block the European parliament’s attempts to cap bonuses to 100% of salary – a ceiling sure to frighten bankers away.

Establishment woes
A second challenge for the UK is that the banking industry is only the latest pillar of national life to be humiliated for corruption and greed. The media and police are mired in the phone-hacking and bribery linked to newspapers from Rupert Murdoch’s News. Politicians are still damaged by allegations in 2009 they had rorted their expenses for years.

More than 340 of the 646 members of the House of Commons were quizzed on irregularities that year and at least four lawmakers were convicted (two going to jail) for fraud. Companies are slammed for their excessive executive salaries and corruption – GlaxoSmithKline, for example, was fined US$3 billion for mis-marketing anti-depressants to children. The Church of England is fractured. It appears that only the public service, the judiciary and the royal family, apart from Prince Harry after his nude frolics in Las Vegas, have escaped disgrace.

The repercussions of the collapse of public faith in institutions are likely to be large over time. Social divisions may widen and anti-establishment parties are likely to impress voters while mainstream parties may pander more to populism, all to the cost of economic efficiency at the very least.

Then there is the threat posed to the UK by the eurozone debt crisis. Well might euro-sceptics in Britain gloat that they warned a monetary system without political union was doomed (even if much of the UK opposition to joining the euro reflected an island mentality). But it’s hard to see how the UK can gain from this crisis, even with its own currency and central bank.

There are only two final outcomes for the eurozone debt crisis; the end of the euro or the fiscal and political integration that saves the currency. A collapse of the eurozone would send countries that take nearly 50% of the UK’s exports into turmoil. While consumer and business confidence would be smashed everywhere and financial systems may freeze, the battering would be bigger the closer a country is to the explosion as commercial and business ties are stronger and confidence linkages greater.

Longer term, though, perhaps a bigger danger to the UK is if the eurozone survives and thrives – and don’t underestimate the will of Continental Europe to preserve the integration that has kept Europe at peace since 1945. London’s attempts to safeguard the UK’s interests threaten grand solutions for the eurozone and are costing the UK political goodwill. Eurozone members feel they are being held to ransom when the UK jangles its veto over fiscal and political steps to unification in exchange for exemptions for the UK on related or unrelated matters.

The 17 members of the eurozone, for example, were upset in December when London tried (but failed) to block an EU-wide fiscal compact unless financial regulations were eased for the City. London is fighting to keep the continent-wide bank supervision powers that EU leaders (including Prime Minister David Cameron) approved in June restricted to the eurozone rather than the 27-member EU.

A more-unified eurozone will most likely work to isolate the UK politically and economically. Any referendum that results in the UK leaving the EU to perhaps become, like Iceland, Liechtenstein and Norway, part of the European Economic Area instead will only fan anti-British feelings in the eurozone.
 
Toxic economics
Another peril to the UK is a self-inflicted punch to its economy, which struggles anyway against perennial government and current-account deficits. For ideological reasons rather than in response to any emergency, Cameron is pursuing austerity policies that in fiscal 2011 and fiscal 2012 are removing government spending worth about 4.75% of GDP – and he expects austerity to last until fiscal 2020. After only one fiscal year, the result is a textbook case of how austerity policies during a downturn make everything worse, even the budget deficit (at 8% of GDP in the UK) and government debt levels (80% of GDP) that such policies seek to correct.

The country is suffering its second recession since the financial crisis started and the jobless rate is above 8%. Output has shrunk 0.9% since the third quarter of 2010 just after Cameron came to power in May that year. GDP is 4.5% below its 2008 peak, meaning the country is on course for a longer depression than it suffered during the 1930s.

The country’s triple-A rating from Moody’s, which placed the UK on negative outlook in February, looks vulnerable.
The IMF warns the side effects of a prolonged downturn will trim the country’s long-term growth potential, a curse known as hysteresis. These consequences include the loss of skills among long-term jobless, the destruction of unused capital and underinvestment preventing innovation.

“(The IMF’s) central scenario assumes that hysteresis effects will lower potential GDP growth by about a third of a percentage point annually on average over the medium term, with other lingering effects of the crisis (e.g., restrained global demand for financial services) taking off another fifth of a percentage point,” the IMF says. It’s likely a political and business backlash will force an end to austerity before such damage is done.

Finally, the UK is structurally handicapped for the 21st century. The country is resources poor, has a political system designed to protect the rich through the unelected House of Lords, has an aging population and its class system means a large percentage of its population is kept under-educated when globalisation makes human capital a country’s greatest long-term asset.

There is hope for the UK, though. The London Olympics lifted the mood of the British, may help the economy expand during the September quarter and showcased one area where the UK is shining; namely sport. The UK team finished third on the medal tally, seven spots ahead of Australia.

While its soccer team is brittle and a Briton still can’t win Wimbledon, one claimed this year’s Tour de France, others have won recent golf majors, England’s cricket team held the world No. 1 ranking for a year until losing it to South Africa in August and its rugby team is the only one from Europe to win a World Cup. If after decades of easy-beat status, the British, with government money and foreign (much Australian) know-how, can win at play, there are no reasons why they can’t use the same sort of formula to conquer at work.

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