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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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
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). 1 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 10 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 2 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. 3 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 4 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
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). |