Good afternoon from New Economy Brief.
In July, Chancellor of the Exchequer Rachel Reeves gave her second Mansion House speech, delivered annually by the Chancellor to senior figures in the financial sector at the residence of the City of London’s Lord Mayor. The speech – and the package of measures called the ‘Leeds Reforms’ which accompanied it – committed the Government to an agenda of financial deregulation to boost economic growth. In this edition of New Economy Brief we unpack the rationale behind these regulatory rollbacks and consider the risks of relying on deregulation to deliver growth.
Why the rush for growth?
Rachel Reeves has described her Leeds Reforms as “the most wide-ranging package of reforms to financial services regulation in more than a decade”. The government is set to lower banks’ capital requirements and reform the UK’s ringfencing regime, with Economic Secretary Emma Reynolds tasked with “[striking] the right balance between growth and stability”. Reeves is hoping these measures, along with new initiatives to encourage firms to list shares in London, will attract new businesses to the UK and unlock the finance needed to make them successful.
The Chancellor was clear her objective is “to ensure that regulators are really regulating for growth”, suggesting that “in too many areas, regulation still acts as a boot on the neck of business, choking off the enterprise and innovation that is the lifeblood of economic growth.”
And growth matters – not least because “kickstarting economic growth” is one of Labour’s five missions for government and a central manifesto commitment. Yet growth remains sluggish, with forecasts showing this is likely to continue. This is particularly problematic because there are fears of a gap emerging in the Government’s finances, with forecasters anticipating a large shortfall in public funds relative to spending. Estimates of the gap converge around £20 billion but reach as high as £51 billion if the Office of Budgetary Responsibility has overestimated the UK’s long-term growth potential – according to the National Institute of Economic and Social Research (NIESR). Labour is relying on growth to plug this gap, and the Chancellor is hoping deregulation will help her do it.
Will financial deregulation boost the economy?
Reeves’ justification for rolling back regulations is that they unduly prevent risk-taking, which holds back the UK economy. But it remains to be seen whether banks will take on more risk in order to scale up investment in businesses and support growth in the real economy, or instead shift that risk onto ordinary people while boosting their profits.
There are two important ways that banks can pass on the risk. Firstly, after they make a loan, they have the option of selling the future returns on that loan to a third party. This happened at vast scales in the run up to the global financial crisis, with banks providing credit for high risk mortgages and then selling the debt on to other financial institutions, such as pension funds. Banks pocketed fast profits, while the pension funds were left ‘holding the bag’ when the risky mortgages failed to pay out. Secondly, the banking sector has historically had the advantage of being ‘too big to fail’. In the event of another major financial crisis, the state could be forced to step in once again and bail out the banks to prevent economic collapse. The reforms put in place after 2008 have partially mitigated this risk, but Reeves’ deregulatory agenda threatens to remove some of these protections.
And how is the financial sector likely to allocate the increased investment ‘unlocked’ by looser rules? Unfortunately, the financial sector has a long track record of neglecting lending to consumers and businesses, preferring to allocate credit to the finance, insurance and real estate sectors. Analysis from Positive Money reveals that net lending to the productive sectors of the economy “decreased by £5 billion in 2021, by £5.6 billion in 2022, and by £8.5 billion in 2023.” The regulatory changes Reeves has proposed therefore risk damaging broader economic growth and undermining the Government’s Industrial Strategy, as Finance Innovation Lab’s Jesse Griffiths has argued.
Any new regulatory approach seeking to increase financial risk-taking must ensure the downside remains with those making lending decisions. Failing to do so incentivises excessive risk-taking – an effect known as 'moral hazard'. In the aftermath of the 2008 global financial crisis, higher capital requirements and a robust ringfencing regime for banks were put in place specifically to avoid a repeat of that disaster.
The Leeds Reforms overestimate the contribution of finance to growth and set the UK on course for a deregulatory ‘race to the bottom’, with finance growing as the real economy declines. The UK has housed one of the world’s largest financial sectors for decades, but has nonetheless seen the lowest investment rate in the G7 in 24 of the last 30 years. Far from laying the groundwork for a prosperous economy, the Government’s deregulatory agenda risks growing the financial sector for its own sake.
Alternatives to financial deregulation
So what can the Government do to boost growth, and ensure that the benefits reach the real economy? One effective solution is to increase public investment. Analysis by NIESR shows that a permanent one percent rise in public investment as a share of GDP leads to a 2.2–2.9 per cent increase in GDP growth over 35 years.
The Government did change its fiscal rules to increase public investment at last autumn’s Budget. But the additional £113 billion these changes unlocked is only enough to reverse the deep cuts to public investment pencilled by the previous government’s spending plans. NIESR also argues that despite these changes, “the current UK fiscal framework constrains public investment”.
Instead of hoping that financial deregulation will boost growth and plug the gap in the public finances, the Government could raise taxes without breaking its manifesto commitment to avoid raising taxes on working people. New research by Positive Money argues that a windfall tax on the big 4 UK banks’ record £48 billion profits could raise more than £11 billion.
The way the Bank of England pays interest on the reserves commercial banks hold with it could also be changed. A system of tiered reserves which requires banks to hold some reserves that don’t pay interest – like that outlined by the New Economics Foundation – could save up to £55 billion in the next five years. This money could be channelled into current spending and investment. Former Prime Minister Gordon Brown is supportive.
While they cannot replace the need for public investment, there are policy approaches to boosting growth that do not rely on increasing taxation or borrowing. One is implementing a credit guidance regime: by enforcing upper and lower bounds on how much credit banks can extend to different sectors, the Government can compel banks to channel investment directly into productive areas of the economy. Such an approach has proven effective in the past.
And on the monetary policy side, the Bank of England could offer dual interest rates: rewarding banks that assign a greater proportion of lending to the real economy with a better rate of interest.
The Chancellor is under intense pressure to deliver economic growth. But relying on financial deregulation to provide it risks failing to learn the lessons from the recent past. Rather than giveaways to the financial sector, there are a broad range of fiscal, regulatory and monetary policy tools available to ensure that the real economy is receiving the investment it needs, and to put the UK on track for balanced, sustainable growth.
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