The UK’s ‘Golden Goose’ Industrial Strategy

As a result of Brexit, the UK is no longer required to abide by EU financial services regulations. This means that the legislation which was put in place to ensure economic stability can be revised and absorbed into UK national legislation. The Financial Services and Markets Bill (FSMB), aims to do just that.

In July 2022, Chancellor Nadhim Zahawi gave a speech at Mansion House (MH), proposing a hierarchy of objectives for regulatory reform: financial stability; consumer protection; promoting sustainable growth and international competitiveness. This complements the recent extension of the remit of the Financial Conduct Authority (FCA) to cover domestic competition issues in the sector. The FSMB, drawn up following the MH speech, is designed to supplant the 2012 Financial Services Act, and is currently at Committee Stage, meaning amendments can be considered.

The FSMB proposes that current independent regulators (the FCA and the PRA- Prudential Regulation Authority) remain integral to the process of rule setting, but with HM Treasury providing public oversight, along with their relevant Parliamentary Committees. It is also proposed that the Treasury can require the regulators to review rules when the government considers this to be in the public interest.

A key proposal is the overhaul of the ‘Solvency II’ capital requirement for insurance companies, inherited from the EU, announced in the 2022 Autumn Statement and backed by the Treasury, despite the PRA’s reservations. It is hoped that this will stimulate greater infrastructural investment by insurance companies compliant with the government's net zero carbon emission commitment by 2050. It also further supports the June 2021 establishment of the operationally independent, but state-owned with Treasury oversight, UK Infrastructure Bank (UKIB): to support the net zero strategy; growth in regional and local sectors (‘levelling-up’); and digital infrastructure investment.

The potential for Treasury encroachment on the turf of the Department of Business, Energy and Industrial Strategy is noted in passing. In the recent Autumn Statement, Chancellor Jeremy Hunt replaced the potentially very costly investment zones proposed by his predecessor (Kwasi Kwarteng) with a more limited programme of knowledge-intensive clusters. This new proposal clearly shows signs of Treasury involvement. A major aim of these proposed regulatory reforms is to bolster the London's capital markets, thus enhancing the competitiveness of the City as an international financial centre.

The UK currently enjoys a high financial regulatory reputation, which was hard earned within the EU. Following the debacle of the ‘light touch’ regulatory regime that culminated in the 2007-9 financial crisis, it was necessary to perform a major regulatory tightening, now enshrined in the current Financial Services Act. Due to this, the UK needs to tread carefully, as any hint of financial activity at the expense of the world’s other leading financial centres could prove damaging.

Another goal of these regulatory reforms is to promote London as a leading centre for financial technology innovation (for example fintech and blockchain), and notably for trading in crypto assets. This goal seems questionable. A similar attempt to develop and dominate an international market for the Chinese Renminbi (Yuan), which was expected to increasingly challenge the mighty U.S. dollar, was quickly brought down by global developments. Further, the very public travails of the crypto and token based market over the past year, including the collapse into bankruptcy last week of the FTX cryptocurrency exchange, make the future of this asset class uncertain.

Yet another London-centric goal is to promote the City as a major centre for issuing and trading green bonds, which raise finance for environmentally friendly projects. Currently, Frankfurt is ahead of London by a significant margin because Germany’s development bank both issues and invests in green bonds. The Treasury should encourage UKIB to scale up by issuing green bonds and Treasury backing would establish a benchmark for this market.

The financial and related professional services sector accounts for around 10% of UK economy, with 2/3 of its employees outside of London in other major cities such as Edinburgh, Birmingham and Leeds. This sector lays ‘golden eggs’ in the form of major tax contributions - over £100 billion per annum – and a large (net) contribution to exports, helping to reduce the UK's burgeoning trade deficit.

It is hoped that the recent removal of the EU required cap on bankers bonuses will help to attract highly skilled global workers, further enhancing the city’s competitiveness. This should be complemented by a more supportive immigration regime, generating yet more tax income. The sector could potentially contribute further tax revenue if the government were to raise the VAT on financial services from 0% to the standard rate of 20% - with potential exemptions, for example for cash withdrawals and payments services. Additionally, an extended stamp duty on traded assets (a financial transactions tax) or a financial activity tax might be considered.

In summary, the government is pursuing an industrial and regional policy that involves promoting the City and the wider financial and professional services sector by offering judicious regulatory reform and via the UKIB, which is expected to leverage its government funding with private sector infrastructural investments. Insurance companies and pension funds are both seen increasingly as sources of infrastructural, and perhaps other, investment to be unlocked. Nicholas Lyons recently proposed the establishment of a specially created sovereign wealth fund to which pension funds could contribute for this purpose. The liquidity crisis faced by pension funds as a result of their financial derivative-based liability-driven investment (LDI) strategies when gilt yield rose sharply following the September ‘mini-budget’ suggests caution - and the genuine matching of the durations of pension fund assets and liabilities!

Arguably the most fundamental function of the financial sector is to allocate capital. The better it is regulated and governed, the more efficiently it will do so; thereby sponsoring UK innovation, productivity increases and sustainable economic growth. If the forthcoming Financial Services and Markets Act can indeed help enhance the sector's efficiency, then perhaps it is sufficient as the industrial strategy. However, it seems the focus on the City of London is somewhat singular, whereas the regional part of the strategy has suffered neglect and will need further work.