Financing Investment Reforming finance markets for the long-term Alfie Stirling and Loren King ippr commission on Economic Justice
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Financing Investment Reforming finance markets for the long-term Alfie Stirling and Loren King IPPR Commission on Economic Justice Discussion Paper Get in touch For information or to contact the IPPR Commission on Economic Justice, please email: Louise Rezler, Programme Manager IPPR Commission on Economic Justice cej@ippr.org www.ippr.org/cej This paper was first published in June 2017. © 2017 The contents and opinions in this paper are the authors’ only.
McKinsey and Company Sara Bryson, Community Organiser, Tyne & Wear Citizens, Citizens UK Matthew Clifford MBE, Co-founder and CEO, Entrepreneur First Charlie Cornish, Group Chief Executive, Manchester Airports Group Plc Claire Dove OBE, DL, Chief Executive, Blackburne House Group; Former Chair of Social Enterprise UK
College, University of Cambridge; Professor Emeritus, Judge Business School
LocalGlobe Sandra Kerr OBE, Race Equality Director, Business in the Community Lord Bob Kerslake, Chair of London’s King’s College Hospital NHS Foundation Trust; Former Head of the Civil Service
Policy Research Catherine McGuinness, Chairman, Policy and Resources Committee, City of London Corporation
Officer, Siemens UK Sir Charlie Mayfield, Chairman, John Lewis Partnership Prof. Mariana Mazzucato, Professor in the Economics of Innovation and Public Value, University College London
Investing, Legal & General Investment Management; Chair of the Investment Association; Founder of the 30% Club Frances O’Grady, General Secretary, Trades Union Congress Stephen Peel, Founder and Chariman, SMP Policy Innovation Mary Senior, Scotland Official, University and College Union Hetan Shah, Executive Director, Royal Statistical Society Mustafa Suleyman, Co-founder and Head of Applied AI, DeepMind Sally Tallant, Director, Liverpool Biennial Festival of Contemporary Art Neera Tanden, President, Center for American Progress The Most Revd and Rt Hon Justin Welby, Archbishop of Canterbury, Church of England; Head of the worldwide Anglican Communion IPPR Commission on Economic Justice The IPPR Commission on Economic Justice is a landmark initiative to rethink economic policy for post-Brexit Britain. Launched in November 2016, the Commission brings together leading figures from across society – from business and trade unions, civil society organisations and academia – to examine the challenges facing the UK economy and make practical recommendations for reform. The Commission is undertaking a wide-ranging programme of research and policy consultation on issues including industrial strategy, macroeconomic policy, taxation, work and labour markets, wealth and ownership, sub-national economic policy and technological change. Through a major programme of communications, events and stakeholder engagement it aims to contribute to both public debate and public policy on the economy. Non-partisan, it has been welcomed by both government and opposition parties. The Commission’s Interim Report will be published in September 2017 and its Final Report in September 2018. www.ippr.org/cej IPPR Commission on Economic Justice ABOUT THE AUTHORS Alfie Stirling is a senior economic analyst at IPPR. Loren King was an economic analyst at IPPR when this report was authored. NOTE The Commission publishes discussion papers to contribute to debate on issues of major importance. These discussion papers should not be taken to represent the collective views of the Commission or the views of individual commissioners, or the organisations with which they are affiliated. They reflect only the views of their named authors. The Commission welcomes responses and reactions to them.
We would like to thank the members of the Commission task group on finance for investment for their contributions to the research and for the debates which improved this discussion paper. We would also like to thank members of our Panel of Economic Advisers who made comments on earlier drafts of this paper. Thanks are also due to a wide range of organisations and individuals who submitted evidence to the Commission and with whom we discussed the issues. Finally, thanks are due to Michael Jacobs, Director of the Commission, for his comments and guidance at various stages of this project – his advice improved this paper immeasurably. Any errors in this discussion paper remain those of the authors alone. THANKS IPPR is extremely grateful to Aviva for their support for this project, and to the Friends Provident Charitable Foundation, the City of London Corporation, the TSSA, and a number of individual donors for their support of the Commission. Their support should not be taken as agreement with the content of this or other Commission publications. Download This document is available to download as a free PDF and in other formats at: http://www.ippr.org/publications/cej-financing-investment
If you are using this document in your own writing, our preferred citation is: Stirling A and King L (2017) Financing Investment: Reforming finance markets for the long-term, IPPR. http://www.ippr.org/cej-financing-investment Permission to share This document is published under a creative commons licence: Attribution-NonCommercial-NoDerivs 2.0 UK http://creativecommons.org/licenses/by-nc-nd/2.0/uk/ For commercial use, please contact info@ippr.org
IPPR | Financing Investment Reforming finance markets for the long-term 1 Contents Summary ..........................................................................................................................2 Introduction ....................................................................................................................4 1. The profitability of the UK’s finance sector rests in part on a failure to pass on the benefits of its rising productivity to the rest of the domestic economy ....................................................................................................7 Are finance markets serving the rest of the economy? ......................... 10 2. Boosting SME investment further requires shifting the focus of bank lending to small, high-growth firms, and the development of new specialist banks .........................................................................................14 Is there still a finance gap? .......................................................................... 15 The problem of real estate ...........................................................................17 Policy proposals ............................................................................................. 19 Specialised banks .........................................................................................20
Intermediating ownership – for whom and what purpose? .................. 23 The growth of intermediaries ......................................................................24 Misaligned incentives – quantity over quality ......................................... 27 Misaligned incentives and agency capitalism .......................................... 29 Supporting responsible stewardship ......................................................... 31 Tax reform – hardwiring new incentives ................................................... 32
IPPR | Financing Investment Reforming finance markets for the long-term 2 Summary The reform of financial markets is vital if the UK is to be upgraded to a high-investment, high-productivity and high-wage economy. The financial sector is a major employer and earner of foreign exchange, but it is not sufficiently supporting long-term investment in the UK domestic economy. Small, high-growth firms are frequently unable to access the bank lending they need, while the markets and institutions that trade shares in public companies have created excessive pressures towards short-termism. Reform of the UK’s financial sector should therefore be focused both on improving the flow of capital to the businesses most in need of investment, and aligning the incentives among company directors, intermediary institutions and savers to promote longer-term investment. This conclusion is based on three key propositions: 1. The profitability of the UK’s finance sector rests in part on a failure to pass on the benefits of its rising productivity to the rest of the domestic economy. Despite huge advances in information technologies and analytical capacity, the unit cost of intermediation to the non-financial economy was higher in 2007 than it was in the 1950s. •
countries, the UK spends around 2 per cent of GVA on research and development (R&D), compared with 3 per cent in France and the US, and closer to 4 per cent in Japan and Finland. •
They also affect business demand for investment by intermediating the ownership of companies through share dealing. •
markets are not supporting the rest of the economy as they should. The unit cost of intermediating capital for the UK’s non-financial economy rose by a third between 1950 and 2007.
UK banks are overly focused on real estate, leaving a gap in the supply of finance needed to improve productivity and growth in the economy. •
appears to be a significant finance gap for small, high-growth businesses, which are particularly important to shift the UK to a higher wage, higher productivity economy. •
banks is three times the average across the Eurozone. •
IPPR | Financing Investment Reforming finance markets for the long-term 3 3 3 supporting the private sector to use intellectual property as collateral. Continuing to rely on horizontal interventions alone, such as the Funding for Lending Scheme, will not ensure finance reaches all the places it is most needed to upgrade the economy. •
or geographic regions, specialist and public investment banks (such as the Green Investment Bank, or Germany’s KfW) are able to develop expertise and thereby ‘crowd-in’ private investment. 3. Promoting longer-term corporate investment requires a stronger alignment of the incentives of companies with the savers who ultimately own their shares. By reforming executive pay, extending fiduciary duty to intermediary institutions such as fund managers and brokers, and ending exemptions for Stamp Duty Reserve Tax, the incentives for excessive short-termism in equity markets can be reduced. •
performance, not long-term value creation, with high frequency trading adding negligible value to the economy. Hedge funds, high frequency traders and propriety traders now make up 72 per cent of equity market turnover in the UK. •
company board rooms, leading to an excessive focus on share prices and short-term returns to shareholders. A survey of more than 400 executives found that 75 per cent would sacrifice positive economic outcomes if it helped smooth short-term earnings. •
managers and brokers would help align the incentives between companies and the savers who ultimately own their shares. A new Responsible Ownership Commission should be established to apply the principle and support disclosure and compliance. •
from Stamp Duty Reserve Tax, in order to reduce the incentives for short-term trading. The revenues generated could be used to create new reliefs in Corporation Tax and Capital Gains Tax to increase incentives for longer-term ownership of shares.
IPPR | Financing Investment Reforming finance markets for the long-term 4 Introduction Superficially at least, there appears to be a paradox at the heart of the UK economy. Despite privileged proximity to one of the largest finance sectors in the world, UK firms invest less as a proportion of GDP than most of our competitors. Upon further inspection, however, this paradox is only skin deep. The UK’s largest firms have been net savers in the economy for a number of years. In aggregate they have more than enough cash from retained income to fund present levels of investment. Meanwhile banks and other intermediaries make huge profits from trading instruments and assets with one another and the rest of the world, not just from investing in the UK’s non-financial economy. It is little surprise, then, that the size and success of UK financial firms bears little relation to the investment performance of the rest of the economy. Nevertheless, the uncomfortable juxtaposition of low investment levels and a highly profitable finance sector does raise serious questions about how well the finance sector is serving the British economy. It is possible to think of finance as a sector with two interrelated purposes. The first is to generate jobs, profits and tax receipts particularly by exporting services to the rest of the world, innovating in and diversifying risk management, while helping to uncover the market price of debt and credit. The second is to safeguard the savings of UK-based investors, intermediating the ownership of UK companies in the interests of the wider economy and ensuring that companies wanting to invest get the finance they need. Since the financial crisis, understanding the way in which finance markets can shape the rest of the economy has gained new salience among policy makers and experts. On the regulatory side, the Coalition Government brought in a suite of reforms with the 2013 Banking Reform Act – though they did not go as far as the post-crisis Commission on Banking had recommended. Among other things, the Act obliged banks to separate their investment banking activities from retail services provided to individuals and small businesses. It also created the new Prudential Regulation Authority to oversee banks’ behaviour under the new rules. The Bank of England has also taken additional measures to intervene directly in the incentives of financial markets in an attempt to improve their contribution to the real economy. From 2009, Quantitative Easing has been intended to free up cash for institutional investors to push money towards non-financial firms, while the Funding for Lending Scheme has provided incentives for banks to lend more to small and medium sized businesses. Most recently, the Term Funding Scheme provided additional funding for private banks on terms close to the Bank of England’s overnight base rate. Taken together, the primary focus of public interventions during the last two parliaments has been to improve the safety (on the regulatory side) and the volume (on the incentives side) of investment. The latter has seen some modest successes, while the former remains untested. Very little effort, however, has been paid to improving the quality of finance for business, and especially to how markets can shape its demand, as well as supply. It has long been argued that finance markets have disproportionately short-term horizons. Survey evidence from the 1960s suggested that investment funds would typically expect a full pay-back on an investment within five years, despite the average effective life of industrial hardware at the time being at least 15 to 30
IPPR | Financing Investment Reforming finance markets for the long-term 5 years (Neild 1964). Yet further empirical evidence on excessive short-termism in the following decades was drowned out by the prevailing dominance of the ‘efficient market hypothesis’: the idea that stock market prices always perfectly reflect the true value of assets (Fama 1970). Rational investment decisions, therefore, would always deliver an optimal return for the economy in the long term. More recently, empirical studies have consistently shown that short-termism is a serious and demonstrable problem. Stock markets, particularly in the UK and the US, appear to be consistently applying a disproportionately high discount to longer-term investment – well in excess of that implied by their true value to the economy (Haldane and Davies 2011, Kay 2012). This pushes capital flows towards shorter-term investments, with significant opportunity cost to society and the economy. In response to this new body of evidence, the Prime Minister, Theresa May, announced in November 2016 the launch of a Patient Capital Review, to be led by the Treasury and advised by an industrial panel led by Sir Damon Buffini (HMT 2016). It will focus specifically on investment in start-up and scale-up companies. Concurrently, the Bank of England has been exploring this area with new research and surveys looking to understand the extent of productive investment in the UK. The Bank’s work adds to a significant academic literature since the financial crisis, looking at the role of the financial sector and how it can be reformed to better serve the rest of the economy. Notable examples include work by Adair Turner (2010) and John Kay (2015). Although welcome, these recent policy interventions mark just the beginning of the work that needs to be done to ensure the UK’s finance sector provides maximum value for society. The internationally unusual size of the finance sector in the UK comes with a mixture of opportunity and risk. Its profitability attracts investment and talent from overseas. By contributing to the rise in prices of real estate and other assets our financial system also helps firms with access to collateral leverage credit, while its sheer size can help to mitigate and spread risk, making possible more productive and innovative ventures. However, the profitability of finance can also divert investment away from the real economy, where opportunities may be less attractive by comparison, especially if they are long-term in nature. The generation of asset bubbles accentuates this problem, while also presenting systemic risks for the economy as a whole. Meanwhile large inflows of overseas spending on financial services may help to keep the value of Sterling artificially high, which in turn makes UK exports less competitive and less attractive as an investment opportunity. This discussion paper is focused on the relationship between the finance sector and business investment. It covers the role of finance in providing both capital and stewardship for businesses seeking to generate long-term economic value. It does not cover questions around systemic risk, interest rates, consumer banking or exchange rates, which will be examined as part of the Commission on Economic Justice’s separate work on UK monetary policy. Questions around the role of finance in the distribution of power and wealth more widely will also be considered separately by the Commission. The Commission’s deliberations have been assisted by submissions received in response to our call for evidence, and consultation with experts and stakeholders in the field. Our research has led us to three key propositions, which we put forward for debate:
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