UK’s finance-business chasm is as wide as ever

The committee studying the financial state of British business did not pull its punches. After a lengthy investigation, the government-appointed panel of economists and experts concluded UK financial institutions were less supportive of domestic companies than their rivals in Europe and the United States. To revive the sluggish economy and moribund stock market, the group recommended sweeping reforms to funnel long-term capital to industry.

This description could sum up the work of the multiple task forces and committees that have recommended changes to Britain’s financial sector in recent years. Yet this particular group reached its conclusion almost a century earlier. The Committee on Finance and Industry was set up in 1929, the year of the stock market crash, under the leadership of Hugh Macmillan, a Scottish lawyer. Its members included luminaries such as the economist John Maynard Keynes and Ernest Bevin, the trade union leader. Its diagnosis of the chasm between British finance and industry was so damning that financiers and policymakers were still debating the “Macmillan Gap” many decades later.

Now British politicians, investors, and regulators are once again fretting about a dearth of financial support for home-grown enterprises. The number of companies listing on the London Stock Exchange has plummeted. UK-listed stocks trade at a hefty discount to American equities. British entrepreneurs complain about a lack of financing for fledgling ventures. The country’s investment track record is one of the worst in the developed world. The government, faced with high debt and a spending squeeze, is poorly placed to help.

Ministers and watchdogs have responded with a frenzy of regulatory reform. They have tweaked pension rules, lowered requirements for stock market-listed companies, and reversed restrictions on paying for investment research. Before leaving office, the last Conservative government gave Britain’s financial regulators explicit responsibility for boosting international competitiveness, reinstating a requirement that had been removed by a previous Conservative government in 2012.

At a packed summit in the City of London last week Julia Hoggett, chief executive of the London Stock Exchange, hailed the latest shakeup as “the most ambitious capital markets reform agenda anywhere in the world at the moment”.

These periodic overhauls rest on a seductive idea: changing financial rules and tweaking taxes can help to unlock a torrent of fresh investment that will stimulate British companies and revive economic growth. Yet this analysis ignores the deep fault line that separates the country’s financial industry from the rest of the economy.

The United Kingdom is unusually dependent on finance. Financial services account for about 12 percent of economic output, compared with around 7 percent in the United States.

Much of that activity emanates from London. The City is the world’s second-largest asset management hub, the leading venue for foreign exchange trading, and the number one location for over-the-counter derivatives. British companies can and do make use of these services, but London’s success as a financial centre depends on attracting clients from around the globe.

This lopsided arrangement has endured for centuries. As the historian David Kynaston pointed out in “Till Time’s Last Sand”, his history of the Bank of England, the City long favoured merchants and traders over domestic industrialists. It was the financial heart of the British Empire, and then became the main banking hub for the European Union. The wealth and tax revenue it generates inevitably distorts the domestic economy. Indeed, the promise of earning a fortune in the City has long lured ambitious young Britons who might otherwise have pursued careers in other industries.

The dominance of finance has also contributed to short-term decision-making.

In 2011, the UK government asked the economist John Kay to study whether equity markets were helping UK companies and providing good returns for savers. He concluded that mistrust and misaligned incentives led firms to make bad decisions. The continued rise of passive index-tracking investment funds and the growth of private equity over the subsequent decade added to the problem.

Recent and potential future reforms appear too timid to reverse these trends. Take the current debate over the absence of UK stocks from the portfolios of British pension funds. It’s striking that the UK retirement industry invested just 4.4 percent of its assets in domestic equities last year, according to a study by the New Financial think tank. This proportion is much higher in some other countries with large pension industries, such as Australia and South Korea.

But it does not necessarily follow that reversing the decline will make British investors more supportive of home-grown businesses. Back in the mid-1990s, when UK stocks made up more than half the value of pension fund assets, executives frequently complained that fund managers in London were obsessed with short-term results, struggled to understand new technologies, and preferred dividends over reinvesting in growth.

Yet the push for reform is showing no sign of letting up. At last week’s summit Nigel Wilson, the former boss of insurer Legal & General, presented a report titled “The Capital Markets of Tomorrow”. His recommendations include giving retail investors more incentives to buy British stocks, reintroducing tax credits for pension funds that invest in domestic equities, and abolishing stamp duty on share trading.

Some delegates also suggested forcing workers to invest part of their salary in a pension.

These recommendations may be well-intentioned. But they also smack of special pleading by an industry that has long played an outsized role in the British economy, with distinctly mixed results.

The Macmillan Committee eventually got its way. In 1945, the Labour government and the Bank of England strong-armed British banks into creating the Industrial and Commercial Finance Corporation, which eventually became the venture capital firm 3i (III.L). Its remit was to provide long-term financing to small and medium-sized enterprises. Despite its efforts, however, the chasm between British finance and business remains as wide as ever.