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

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than real-estate and intra-financial dealings, with balance sheets that contained 

more than twice as many productive real economy assets than their private 

counterparts (ibid). These banks also had the economic benefit of operating 

counter to the business cycle. In the Europe, they were more likely to offer credit 

in the years directly following the recession, counteracting the fall in commercial 

bank lending (Mazzucato 2016). Had the UK also had such banks, it is unlikely that 

credit conditions would have contracted as severely as they did. 

Specialist banking has also seen success in the UK too, albeit on a much 

smaller scale. In 2012, the Government set up the Green Investment Bank (GIB) 

as a commercially viable, public purpose company. By limiting the scope of its 

investment opportunities to four low-carbon sectors – offshore wind, energy 

efficiency, waste and bioenergy and onshore renewables – the aim was to invest in 

commercially viable investment opportunities which conventional finance markets 

regarded as too risky to finance on their own (BIS 2011). Between 2012 and 2016, 

the GIB committed £3.4bn into transactions worth £12bn in the green economy, 

spread over 100 projects. In addition to its investments, it also developed a variety 

of metrics to improve evaluation of green projects. As a specialized investor, it 

has played a major role in boosting standards in the overall investing market 

for commercialised green technology (GIB 2017). Since the GIB’s creation, green 

investments have been steadily growing. In 2015, a record £13.4bn of investments 

in these technologies were made, with GIB directly involved in around two-thirds 

of them by value. 

The specialist mandate of the GIB enabled it to develop expertise which private 

sector lenders could not. It was therefore able to conduct due diligence on 

projects on behalf of other lenders, and reduce the risks they faced. By operating 

as a commercial entity with specialist expertise, the GIB was able to demonstrate 

that there were profitable opportunities in these sectors. In so doing it effectively 

‘crowded-in’ private investment, even in those transactions in which it was not 

directly involved. In the last three years, the GIB reported a forecast project 

level rate of return of around 10 per cent over the lifetime of investments, and in 

2015-16 this yielded profits of around £10 million, contributing to its successful 

sale to the private Australian bank Macquarie Group (Ibid). There is a strong case 

for treating the original model of the GIB as a ‘phase one’ in the creation of new 

specialist banks with comparable mandates focused on either geography or sector. 

There is a comparable case to be made for regional public banks. Here the 

specialist expertise would be geographic: a deep knowledge of local economies 

and the businesses based in them. The scale and size of local banks varies widely 

across Europe, with German Sparkassen typically holding assets between £1 billion 

and £1.5 billion, and serving a population of around 200,000. In the UK we propose 

the initial creation of one or two regional banks at the scale of current Local 

Enterprise Partnerships (LEPs) or combined local authorities. (LEPs on average 

serve a population of a little more than a million people.) The Government should 

seek bids from public authorities and local businesses and trade unions for where 

the first institutions should be located. We propose they start with seed capital of 

around £1 billion in the short-term, and start life as investment funds, similar in 

structure and powers to the GIB. The aim would be to give them borrowing powers 

in the future once the efficacy of their operations had been demonstrated. After 

initially being established as publicly-owned banks, there should be a review and 

transition process that could see a diversity of ownership and governance models 

being adopted, including local shareholders, co-operatives and stakeholder 

trusts, in order to foster both innovation and more broadly-based governance. 

This review could also include consideration of expanding the number of regional 

banks beyond their initial number and considering the case to allow some banks 

to engage in retail services as well. 

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One way for the Government to raise the starting capital for new regional or 

specialist banks would be through its existing shares in the Royal Bank of Scotland 

(RBS). The Government owns roughly 72 per cent of RBS, which at current share 

prices is worth around £22 billion. The Government has long intended to return 

RBS to the private sector: there is a strong case either for creating new regional or 

specialist banks out of RBS, or of using the sale of its shares to fund the creation 

of new institutions. 

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3.  

Promoting longer-term corporate 

investment requires a stronger alignment 

of the incentives of companies with the 

savers who ultimately own their shares

The structure of finance markets affects not only the availability of finance for 

investment, but also the appetite of firms to invest in the first place. This is because 

some finance markets – specifically markets in company shares (equity markets) – 

intermediate the ownership of firms. By doing so they can shape the priorities and 

incentives of company boards, which in turn influences investment decisions. 

Markets in the shares of publicly listed companies are particularly important. In 

the UK, stock markets and their associated institutions and actors intermediate 

the ownership of shares in companies that make up well over half of all turnover 

in the UK’s non-financial economy. In an economic sense, the ‘owners’ of shares 

are those who bear their ‘economic interest’: the potential to gain or lose from 

the value of an asset and its returns. This can be individuals (especially through 

pension funds), other trusts or endowments, or other corporates. 

INTERMEDIATING OWNERSHIP – FOR WHOM AND WHAT PURPOSE?

The majority of those who bear the economic interest of company shares are 

interested in the underlying value and cash flow of their investment over a 

long-time horizon. Individuals might save for a house or a retirement income, 

or for an unknown contingency in their life. Pension funds and insurance 

companies invest to meet future liabilities, and trusts and foundations invest 

to sustain themselves indefinitely (Davis, Lukomnik and Pitt-Watson 2016). A 

significant majority of savers, therefore, are interested in long-term returns. 

Investment for the long term is good for long-term savers. Improving the stock 

of capital used by workers in production processes through the adoption of 

technology, skills and system innovations is a prerequisite for profitability 

over the long term, and therefore to higher earnings and better quality jobs. 

Recent econometric evidence suggests that companies with a long-term view 

deliver a measurably superior commercial performance. For example, a recent 

comprehensive study using data from the US found that companies displaying 

long-term decision making and targeting, performed significantly better in 

terms of revenue, earnings, profits and market capitalisation between 2001 and 

2014 compared with more ‘short-termist’ firms (Barton et al 2017). Over a 13-year 

time horizon, these firms therefore represented a better investment for savers. 

Savers are also citizens. They therefore benefit, not only from a return on their 

investment, but also from the more diffuse impacts that their investments 

have on the wider economy, society and planet across their lifetime – they may 

also care about their children’s and grandchildren’s lifetimes as well. Recent 

evidence again suggests that firms targeting sustainability goals beyond their 

own immediate commercial interests also appear to outperform – even solely 

in stock market terms – companies with seemingly more commercially-driven, 

short-term practices (Eccles et al 2011). This finding is broadly consistent across 

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the academic literature: a systematic review of more than 100 studies confirms 

that ‘environmentally and socially sustainable’ investment decisions yielded 

superior risk-adjusted returns to shareholders (Fulton et al 2013). There seems 

to be little doubt that long-term corporate governance, even – or perhaps 

especially – when it accounts for broader sustainability, performs better than 

short-term governance in terms of narrow profits and returns to savers.

THE GROWTH OF INTERMEDIARIES

Savers, however, rarely bring their interests to bear directly over the decisions 

made regarding their assets. Instead, they rely on a long chain of intermediaries. 

For example, a pension holder will rely on their pension trust to manage their 

investment, the trustee in turn may rely on a number of different asset managers 

to buy and sell or hold shares, who in turn will use nominees to facilitate or 

broker transfers in stocks. Proxy companies may also be used to leverage the 

voting power of shares over the firms who issued them. Most of these stages 

involve armies of researchers, expert advisors, consultants and especially 

computer algorithms to assist in the decision-making process from one part of 

the chain to the next. This increases the number of agents and interests that 

come to bear between the initial savers and the assets they ultimately own.

The number and size of intermediaries in public equity markets has exploded 

in recent years (see figure 8). Between 2000 and 2014, the proportion of 

individuals, insurance funds and pension funds among all direct beneficial 

share owner’s resident in the UK, fell from 85 per cent to 45 per cent (IPPR 

calculations using ONS 2015). Meanwhile the volume of all share transactions 

involving these longer-term investors has fallen from 70 per cent to 40 per 

cent (Persaud 2017). This has not been driven by a decline in these investors as 

a proportion of all economic interests. The number of pension holders in the 

economy, for example, has grown twice as fast as nominal GDP between 2008 

and 2015 (IPPR calculations using ONS 2016 and ONS 2017c). Rather it has been 

driven by the even faster growth in intermediaries, particularly asset managers.

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FIGURE 7

The proportion of individuals, insurance funds and pension funds among all direct 

beneficial share owner’s resident in the UK has fallen significantly

Proportion of individuals, insurance funds and pension funds among all owners of UK shares 

that are resident in the UK, 1963 to 2014

Individuals

Insurance companies

Pension funds

0%

22.5%

45%

67.5%

90%

196

3

19

75

1989

1991

199

3

199

7

1999

200

1

2003

2006

20

10

20

14

Note: the total number of UK resident owners fell from 93 to 46 per cent over this period as 

the proportion of oversea investors rose. The ONS does not disaggregate oversea owners by 

type of institution, but the proportion of individuals, insurance companies and pension 

among all owners is thought to be similar to that among UK residents. Data between 1998 

and 2008 are partially based on ONS analysis conducted in 1997.

Source: IPPR calculations using ONS 2015

The problem – from the point of view of both firms and their workers on the 

one hand, and savers (many of whom are also workers) on the other – is that 

the growth in intermediaries in the UK appears to have coincided with firms 

increasingly using finance for things other than long-term investment. 

In theory, increasing the number of intermediaries can lead to either improved 

or worsened efficiency, depending on how well markets and institutions 

are operating. A resource-based theory (RBT) of firms would suggest that a 

company entity represents an economic frontier between, on the one hand, 

the efficiency of transactions intermediated by a market, and on the other, the 

efficiency of internalised transactions (Barney et al 2014). Put simply, firms exist 

because some transactions are more efficient when internalised (for example 

the payment of a salary in exchange for labour). From the point of view of the 

economic principal – in the case of business finance this could be either savers 

or companies depending on which end of the intermediation chain you start 

with – externalised market transactions are most efficient when they allow for 

division of labour, while still aligning the incentives of intermediaries with their 

own. However, this efficiency can break down if incentives can’t be aligned and 

intermediaries are able to charge excessive economic rents. In this instance, 

internalised transactions can be more economically efficient, benefiting from a 

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lower transaction costs and intangible advantages such as corporate culture and 

collective knowledge (Sirmon et al 2007). 

From the work of Philippon and Bazot presented in chapter 1 we know that, in 

aggregate, financial markets are charging excessively high transaction costs to 

the rest of the economy. Given this, it is likely that increased fragmentation and 

division of transactions represents reduced efficiency from the point of view 

of companies and savers. We certainly know that the increase in number of 

intermediaries has coincided with a reduced tendency from firms to invest. Over 

the last quarter of a century, the proportion of profit that UK companies have been 

distributing to shareholders, rather than reinvesting into their businesses, has 

been increasing (see figure 9). For UK non-financial corporations, the proportion 

of discretionary cash flow returned to shareholders increased from 39 per cent 

in 1990 to 46 per cent in 2016 (Tomorrow's Company 2016). This is also consistent 

with Bank of England survey data that shows only around 25 per cent of finance 

raised by companies is spent on investment, with the remainder split between 

purchasing financial assets, distributing to shareholders and maintaining as cash. 

This trend is not unique to the UK. Analysis of McKinsey’s Corporate Horizon Index 

shows that the median company on the Standard and Poor stock market became 

significantly more short-term between 2000 and 2014 (Barton et al 2017). 

FIGURE 8

The UK corporate sector is now a net saver, not a borrower, and investment is declining

Proportion of UK non-financial corporation cash flow allocated to investment, dividends and 

saving, 1987–2014 

80%

70%

60%

50%

40%

30%

20%

10%

0%

-10%

-20%

198

7

1988 1989 1990 1991 1992 199

3

1994 1995 1996 199

7

1998 1999 2000 200

1

2002 2003 2004 2005 2006 2007 2008 2009 20

10

20

11

20

12

20

13

20

14

Investment in fixed assets

Cash paid out in dividends

Net saving / borrowing

Net saving / borrowing

Source: Tomorrow’s Company 2016: 11

The combination of these three empirical observations – excessive transaction 

costs, increasingly fragmented intermediation and reduced investment from firms 

– represents something of a smoking gun. Do the dynamics within equity markets 

contribute to the problem of low investment by misaligning the incentives of 

savers and firms? In this chapter we argue that the dynamics of intermediation 

are indeed leading to a misalignment of incentives. In particular, the driving force 

for this misalignment is the manner in which intermediaries make their money: 

essentially based on the volume, and relative performance of their activity rather 

than the absolute value they create. 

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MISALIGNED INCENTIVES – QUANTITY OVER QUALITY

The first important dynamic that contributes to a misalignment of incentives in 

equity markets is rewarding volume irrespective of results. Most asset managers 

are paid for the size and frequency of their activity. In the first instance, this 

takes the form of an ‘asset-based fee’: the payment made to an asset manager 

calculated as a flat proportion of the size of the fund they are managing, and 

irrespective of any returns generated (Investment Company Institute 2013). 

Brokers are also normally remunerated for the number and value of transactions 

they oversee, and consultants are given a base fee for their advice, irrespective 

of results (Kay 2012). In the former case, this can lead to investment banks failing 

to raise concerns about corporate governance for fear of being less attractive to 

brokers and asset managers (Waygood 2014). And in the latter case especially, 

this has helped to develop a systematic bias towards action over inaction, 

irrespective of rationale. Because of the opacity of finance markets, it can often 

be difficult to discover whether advice is good advice, even after share prices 

are realised (Kay 2012). Given this relative protection against risk, advisors and 

analysts expect that they are more likely to receive future custom if they advise 

clients to do something, rather than to do nothing (Ibid). In turn, this has led 

to further cognitive errors in the form of optimism bias, excessive aversion to 

loss, and ‘anchoring’, whereby sense is made of information overflow by creating 

narratives around data that does not actually exist (Ibid).

Performance is of course also measured and rewarded, but crucially it is too often 

relative performance that counts. The ‘efficient market hypothesis’ would suggest 

that, given full information, markets will achieve prices that reflect all knowable 

information at the lowest possible transaction cost to the owners and recipients 

of capital. This happens through asset managers – as well as portfolio managers 

within insurers and pension funds – working as ‘market makers’, researching the 

value of companies and using that information to buy and sell shares. In this way, 

information feeds into prices, ensuring that the latter reflects the fundamental 

value of the firm that issued the shares. However, as John Kay found in his 

report for the Coalition Government, in practice the problem lies in reconciling 

two contradictory time horizons (Ibid): the horizon over which asset managers 

are rewarded for their analysis of firms; and the horizon over which the price 

of shares will move to reflect their fundamental value, assuming they ever do. 

Asset managers will not be rewarded if information is immediately incorporated 

into prices, nor will they be rewarded if information is never incorporated: there 

needs to be a gap (Ibid). But at the same time, the larger this gap in horizons, 

the less incentive asset managers have to research fundamental value. Instead, 

the incentives to base decisions on what other market actors are doing becomes 

stronger. Successful managers, then, become those that best anticipate the 

behaviour of other managers, not the fundamental value of shares: what Keynes 

famously described as a ‘beauty contest’ (Keynes 1936). 

The beauty contest produces diametrically opposite results from the efficient market 

hypothesis. If there is full public knowledge then the beauty contest results in an 

infinity of possible equilibria, whereas the efficient market hypothesis would reflect 

the real general equilibrium of the economy (Morris and Shin 2002). This is because 

the efficient market hypothesis assumes that market actors are feeding information 

about the so called ‘real’ economy into prices, whereas the beauty contest assumes 

actors are feeding in information about themselves. This can explain why funds 

and profits might disproportionately flow towards managers that oversee superior 

relative performance irrespective of (or sometimes counter to) their ability to identify 

or create long-term value in the equity they hold (Morningstar 2017). 

Frequency and speed, therefore, are perhaps the key features of successful 

relative performance. Fast trading computers located adjacent to stock market 

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