Financing Investment Reforming finance markets for the long-term Alfie Stirling and Loren King ippr commission on Economic Justice


IPPR  |   Financing Investment Reforming finance markets for the long-term 6



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cej-finance-and-investment-discussion-paper-a4-report-17-07-21


IPPR  | 

 Financing Investment Reforming finance markets for the long-term



6

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 is higher now 

than it was in the 1950s



2.  Raising SME investment requires shifting the focus of bank lending to small, 

high-growth firms, and the development of new specialist banks. 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

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. 

The evidence and arguments for these propositions are gathered together in the 

following chapters. In each case we set out the direction we believe that policy 

should take to address the problems we have identified. We welcome responses. 


IPPR  | 

 Financing Investment Reforming finance markets for the long-term



7

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

 

DOES THE UK HAVE AN INVESTMENT PROBLEM?

Economic output is dependent upon investment, yet the UK has significantly 

lower investment relative to comparable advanced nations. Business spending on 

replacing or expanding capital in the UK is worth around 17 per cent of gross value 

added (GVA), compared with around 20 per cent in Germany and 22 per cent on 

average across the Eurozone (World Bank 2016). Over time this has left the stock of 

capital in the UK economy far lower – both when measured as a ratio to GDP or per 

worker – than the most successful advanced economies (see figures 1 and 2).



FIGURE 1

Over time the stock of capital in the UK relative to GDP has fallen well behind that of 

comparable advanced economies

Ratio of total economy capital stock at replacement prices over GDP, 1950 to 2014

Germany

United 

Kingdom

United 

States

France

Japan

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

1990

20

10

20

15

2005

2000

1995

1960

1980

1985

19

75

19

70

1965

1950

1955

Source: Adapted from Bank of England 2016



IPPR  | 

 Financing Investment Reforming finance markets for the long-term



8

FIGURE 2

Over time the stock of capital in the UK relative to the workforce has fallen well behind 

that of comparable advanced economies

Ratio of total economy capital stock at replacement prices over workforce, 1950 to 2014

Germany

United 

Kingdom

United 

States

France

Japan

0

50

100

150

200

250

300

350

1990

20

10

20

15

2005

2000

1995

1960

1980

1985

19

75

19

70

1965

1950

1955

Source: Adapted from Bank of England 2016

There are two possible explanations for low investment in the UK: either demand 

for investment is low; or the supply of credit for investment is sub-optimal. Both 

could be true. 

The UK non-financial economy is certainly structurally different from many of its 

competitors in a way that affects demand for finance and investment. Since the 1970s 

the UK has moved away from more capital-intensive, higher paid industries towards 

more labour-intensive, lower paid services. While some movement of this kind 

has occurred in all advanced economies, the shift has been much more stark and 

dramatic in the UK than in many other countries (Jacobs et al 2016). Manufacturing 

in the UK now makes up just 10 per cent of the economy’s total GVA, compared with 

23 per cent in Germany and 12 per cent in the US (OECD 2016). Recent GDP growth and 

record levels of employment in the UK have coincided with a stalling of productivity 

growth since the financial crisis that is almost without precedent, both in terms of UK 

history and by international comparison. This has in turn contributed to the slowest 

recovery in real wages of almost any country in the OECD since 2007 (IPPR analysis 

of OECD 2017). This would suggest that the UK economy is in some form of ‘low-wage 

equilibrium’ (Hyun Soo 2014). In aggregate, companies are maintaining high growth 

and output, not by adding to their stock of capital (whether tangible or intangible), 

but by adding to their workforce with cheap labour. 

The recent rise in self-employment in the UK – from around 12 per cent in 

2001 to just under 15 per cent in 2016 – is symptomatic of this trend. Many of 

the self-employed might be described as the ‘disguised unemployed’ – the 

phenomena of people working in activities where their productivity is lower 

than it might otherwise be were effective demand to be higher (Eatwell 1997).



IPPR  | 

 Financing Investment Reforming finance markets for the long-term



9

The fact that the UK has a relatively low rate of investment because it has a 

relatively labour-intensive low-wage economy, however, is not a good argument in 

favour of maintaining this. It is now widely recognised that the stagnation of wages 

in the UK requires a determined effort to raise aggregate productivity, and that this 

requires greater capital investment (Haldane 2017, LSE Growth Commission 2017). So 

even if the UK’s financial sector were delivering an optimal supply of finance for the 

present low-investment economy, the question would remain: is the finance sector 

fit for purpose to support an increase in investment to drive the UK towards a new 

model of higher productivity and increased wages and living standards?

1

A key issue is whether UK finance is contributing to sufficient long-term investment. 



There is no single measure of long-term investment, but a useful proxy is expenditure 

on research and development (R&D). Among the most advanced nations in the OECD, 

the UK has one of the lowest rates of R&D spending, even after accounting for the 

dominance of service sectors in the UK economy. After adjusting for the composition 

of industry across countries, the UK spends around 2 per cent of GVA on R&D. This 

compares with 3 per cent in France and the US, and closer to 4 per cent in Japan and 

Finland (see figure 3). Business spending on R&D is also likely to be understated in 

countries such the US and Germany, where the private sector benefits significantly 

from integrated state spending on similar activities (Mazzucato 2016). 

Low R&D spending is unlikely to be primarily driven by a shortage in the 

supply of finance, since much of R&D is internally financed. There are then two 

possible demand side explanations: either there are not enough opportunities 

for long-term investment, or else the time horizons over which businesses 

require a return on their investment are too short. Given that R&D spending 

is lower in the UK even after accounting for the structure of the economy, it is 

difficult to explain low R&D spending solely on account of reduced commercial 

opportunity. This would suggest that at least some of the problem lies in the 

interaction of UK corporate governance with UK finance markets (Lazonick 2014, 

Lawrence 2017). 

We do not suppose that this question need only be asked of finance. The structure of finance markets 



can only be one part of the problem to low investment. The Commission is also exploring the equally 

important, if not more important, issues on the demand side to investment as part of our work on 

corporate governance, industrial strategy and macroeconomic policy. 


IPPR  | 

 Financing Investment Reforming finance markets for the long-term



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FIGURE 3

UK spending on R&D is well below many comparable economies

Business spending on R&D as a percentage of GVA, adjusted and unadjusted for sector 

composition (selected countries, 2011 and 2012)

Unadjusted 

business R&D 

intensity

Adjusted business 

R&D intensity

0.00%

1.25%

2.50%

3.75%

5.00%

FIN

JPN

DNK

AUT

SWE

FRA

USA

BEL

CAN

NLD

KOR

DEU

GBR

NOR

IRL

ITA

ESP

NB: Figures are based on estimates of business R&D by fourth digit industrial sectors. Data 

refers to 2011 for Austria, Belgium, Canada, Greece, Ireland, Mexico and Portugal. Data refers 

to 2012 for Denmark, France, Germany, Hungary, Italy, the UK and the US.

Source: OECD 2013

ARE FINANCE MARKETS SERVING THE REST OF THE ECONOMY? 

In many ways, the UK finance sector is world beating. In terms of size, exports, 

employment and profits, our financial system is among the most successful in the 

world. The unconsolidated assets owned by UK-based financial firms are worth 12 

times more than annual GDP (Burrows and Low 2015). The sector accounts for 7.2 per 

cent of all UK economic output (ONS 2017a) and employs (on well-above-average 

earnings) more than 1.2 million people, or around 3.8 per cent of all employees (ONS 

2017b). Financial services are also responsible for a trade surplus worth 2 per cent 

of GDP – more than all other sectors with a net surplus combined (The City UK 2016). 

There are certainly questions over the continued price of this success in terms of 

global and domestic systemic risk. But though not yet fully tested, progress has been 

made in macro prudential regulation since the financial crisis, with the new Basel 

III Accords – which aim to improve bank safety through improved capital buffers – 

set to be fully implemented by 2018. There remain outstanding concerns that UK 

banks are not as well capitalised as US banks, but in general it appears that the first 

purpose of finance as set out in the previous chapter – to provide jobs, profits and 

exports to the UK economy –is being well served. 

But at least part of the second purpose – to provide finance for investment 

and to intermediate ownership for the UK economy – would appear to be more 

problematic. One of the most striking findings of recent research into the 

financial sector is that the ‘unit cost of intermediation’

2

 – the cost the sector 



Defined as the ratio between the value of loans to the non-financial economy as a proportion of GDP 

and the GVA of the finance sector as a proportion of GDP see Philippon (2014) and Bazot (2014) for 

more information, and explanation of adjustments and modelling.



IPPR  | 

 Financing Investment Reforming finance markets for the long-term



11

effectively charges the rest of the economy for its services – has remained more 

or less constant over the last 60 years. This is despite almost immeasurable 

advances in information technologies and analytical capacity over this period, 

including computer chips, the internet, mobile telephony, broadband and data 

analytics (Philippon 2014). A truly competitive market would have ensured that 

the institutions involved in financial intermediation passed on some proportion 

of the productivity gain from these technological advances through lower costs 

to savers and companies. But what we actually see is that the cost of financial 

intermediation in 2007 was a third higher than it was in 1950 – in other words, in 

aggregate the market has failed to pass on these productivity gains to anyone 

outside of the sector itself. This is true both for the US (Ibid) and for the UK, 

Germany and France (Bazot 2014).

New IPPR analysis has sought to provide an update to these findings for a 

broader panel of developed countries. Our analysis shows that in aggregate, 

UK finance is behaving particularly strangely. Borrowing from the novel 

metric pioneered by Philippon (2014), we estimate the unit cost of financial 

intermediation by calculating the ratio between the value of loans to the non-

financial economy as a proportion of GDP, and the gross value added of finance 

and insurance as a proportion of all gross value added in the economy. Figure 4 

plots this ratio as a three-year rolling average. Outside the UK, the OECD average 

has seen a persistent decline in the unit cost of financial intermediation. Between 

2000 and 2014 the cost of intermediating finance across the OECD fell by a third. 

The fall in cost was on a similar scale in Germany and France, and a little larger 

in the US.

3

 Yet in the UK, average costs in 2014 were almost identical to those in 



2000. Furthermore, in the UK the costs rose uniquely during the run-up to the 

financial crisis. This suggests that UK finance firms were especially unusual in not 

passing on any of the benefits of their large profits to the rest of the economy in 

the form of improved efficiency over this period. 

These results are not directly comparable to those of Philippon (2014) and Bazot (2014) since the 



latter two adjust their unit costs to take account of changes in the composition of firms across time. 

IPPR  | 

 Financing Investment Reforming finance markets for the long-term



12

FIGURE 4

The unit cost of financial intermediation in the UK has barely fallen compared with 2000

Ratio between the value of loans to the non-financial economy as a proportion of GDP, 

and the GVA of finance and insurance as a proportion of all GVA, selected countries, 

2000-2014

US

Non-UK OECD average

UK

Germany

France

0.00

1.25

2.50

3.75

5.00

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

NB: OECD average includes selected advanced OECD countries

4

Source: IPPR analysis of data from the Bank of International Settlement (2017) and OECD (2017)

Although a persistently high unit cost of financial intermediation over time does 

not on its own prove a lack of financial efficiency, it should surely provoke concern. 

While the analysis above does not account for structural economic differences 

across countries and across time, the detailed modelling by Philippon and Bazot 

has shown that the cost of financial intermediation has remained high, even after 

controlling for the types of economy to which they are lending. This included 

controlling for variations in the nature and composition of firms and industries 

across time and, therefore, the differing levels of financial risk as the structure 

of the economy has changed through the decades. Unlike other global industries 

that remained commercially viable over the same period, the finance sector has 

not improved the value for money of the services it provides to the non-financial 

economy (Philippon 2014). 

One possible explanation for consistently high unit costs might relate to the 

(lack of) competitiveness of finance markets. But as Bazot has shown, in the 

UK, unit costs rose in both the 1980s and 2000s at a time of deregulation 

and financial innovation when greater competition should have led costs to 

fall (Bazot 2014). Commenting on a similar phenomenon in the US, Philippon 

shows that lack of competition is not the likely cause of persistently high unit 

cost: periods which saw a rise in price coincided more closely with periods 

characterised by fewer barriers to entry, rather than more (Philippon 2014). 

Another possible explanation is that the quality of finance is improving 

across time in a way that is not reflected in the structure of the economy or 

This includes Austria, Australia, Belgium, Denmark, Finland, France Germany, Greece, Hungary, 



Ireland, Italy, Japan, Netherlands, Norway, Poland, Portugal, Russia, Spain, Sweden and the US.

IPPR  | 

 Financing Investment Reforming finance markets for the long-term



13

the size of assets. A candidate for such a phenomenon could be improved 

information harvesting and dissemination, improving the quality, if not the 

size, of intermediated assets over time (all else being equal) and therefore 

contributing to a persistently high unit cost. For example, the rise in unit 

cost during the first half of the 2000s coincided with innovations in ‘originate 

to distribute’ finance and the reestablishment of UK finance as a major 

international service (Bazot 2014). But since these practices were heavily 

implicated in the spread of contagion during the 2007 crisis, the extent to 

which the rest of the economy was benefiting for an improved service was, in 

this case, highly questionable at best. 

At the very least, persistently high unit costs – which are common across a 

number of countries but have shown a particularly unusual profile in the UK 

over recent years – warrants a closer examination of the role of the finance 

sector in supporting investment. This would be true even if policy makers 

wanted to maintain the efficiency of the UK economic model in terms of its 

present low-wage configuration. However, it becomes an imperative if future 

governments want to move the UK to a higher productivity, higher wage 

economy in the future.

There are two possible mechanisms through which business finance markets may 

be part of UK’s investment problem, affecting both the supply and demand for 

investment and long-term value creation:



1.  business finance markets may be systematically failing to provide the 

necessary capital for firms that would otherwise be able to make commercially 

viable investments

2.  business finance markets are affecting the demand for investment by 

instilling the wrong priorities on corporate decision-making through their 

intermediation of company ownership.

Our review of the existing evidence, along with new IPPR analysis, suggests that 

both of these mechanisms are present. Our arguments and evidence are set out in 

the following two chapters.



IPPR  | 

 Financing Investment Reforming finance markets for the long-term



14

2.  

Boosting SME investment further requires 

shifting the focus of bank lending to small, 

high-growth firms, and the development of 

new specialist banks

Following the crisis, external financing for businesses fell significantly, with 

net lending turning negative for six consecutive years (BBAa 2017). The depth 

and extent of the deleveraging in the wake of the crisis reflected not just the 

contraction of economic output, but a severe supply side credit crunch, with 

lenders unwilling to fund all but the safest investments. Bank balance sheets 

were rapidly cut back and the market in securitised business loans was largely 

wound down (Wehinger 2012).

Although lending throughout the economy contracted during the post-crash 

period, small and medium firms were disproportionately affected. Larger firms 

(defined as those having more than 250 employees) typically have access to a 

broader range of funding sources, such as the syndicated loan market and public 

bond markets or public equity markets, as well as their own retained earnings. 

By early 2013, credit conditions for these large firms had improved substantially 

(Deloitte 2014). But a significant finance gap (the difference between funding 

required and the finance offered) – of between £10 and £11 billion in 2013 – 

remained for small and medium sized enterprises or SMEs (NAO 2013). 

In response to this supply side gap, the Bank of England’s Funding for 

Lending Scheme narrowed its focus exclusively to SMEs in 2014. Similarly, 

the Enterprise Finance Guarantee scheme was introduced to give banks a 

government guarantee on their loans to SMEs. At the same time, the Coalition 

Government launched the British Business Bank (BBB) to increase the supply 

of finance to smaller firms less able to get credit. The BBB has tried to reduce 

the risk of investing in SMEs, by providing loss guarantees or matching funding 

for both loan providers and private equity investors. The BBB is particularly 

focused on expanding the array of financing options available to SMEs, as 

part of a wider government effort to increase access to alternative forms of 

finance beyond traditional bank loans. For example, the Enterprise Investment 

Scheme and the Seed Enterprise Investment Scheme provide equity investors 

with tax reliefs on their investments (Hatfield 2017).

Since these interventions, there are some signs that the finance gap for SMEs 

as a whole has closed. Recent survey evidence suggests credit conditions have 

improved, driven both by general economic recovery as well as government 

intervention (Saleheen and Levina 2017). Net lending to SMEs stopped falling in 

2014, and has grown in every quarter since, totalling £1.5 billion in 2016 (BBAa 

2017). Furthermore, alternative sources of financing, including private equity, 

asset finance and peer-to-peer lending have also been on a steady upward trend 

in the last few years (BBB 2017). 



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