Robert Shotton
December 2017

The UK Trades Union Congress (TUC) has published an “Economic and Social Audit of the “City” – the UK’s financial sector, authored by Mick McAteer. It asks whether the City, which is so central to the UK economy, is working effectively to support the real economy, and more particularly, for the benefit of ordinary working people going about their daily lives.

What follows is mostly a resumé of the Report – highly recommended reading – with some additional commentary.
Statistics in the TUC report document the extraordinary expansion of the financial sector in Western economies, and especially in the UK. By 2014, the UK financial sector accounted for £20 trillion of financial assets under management, which represented 1200% of UK GDP, up from an estimated 200% of UK GDP in 1978. That compares to 900% of GDP in Switzerland, 700% in Japan, 600% in France, and only (!) 500% in the USA.

Of the UK’s 1200% of GDP, 350% represents financial assets held by foreign banks. It is estimated that only 50% of financial assets held by UK banks are linked to the real economy and only 10% of financial assets held by foreign banks. So a quick calculation suggests that over 60% of assets held by banks in the City relate to transactions internal to the financial sector, not directly in support of the wider productive economy or its citizens.

Good news or bad news? Some say that with all its faults, the UK financial sector has the great merit of filling the Treasury’s coffers, and helps to sustain public expenditure in general and the welfare state in particular. So, they say, reformers should be very careful not to kill the “golden goose” by excessive regulation. True, the financial sector and related services account for around 12% in 2014 of the UK economy, and a more than proportionate share of private profitability, around 15%. And yet the tax take is around 11.5% of the total, a less than proportionate share of profitability. Not so golden a goose as some might say.

The bad news is neatly summed up already in 2010 by Bill Gross of Pimco, saying that UK gilts (government debt) were “resting on a bed of nitroglycerine”.

Of course, UK regulators are aware. They have been working hard to reduce the vulnerability of the financial sector to risky behaviour and market failure. Fortunately so far, their efforts to prevent another cycle of boom and bust as catastrophic as in 2007/8 have not been tested. But sooner or later, and probably sooner, they are likely to be, because ever since 2007/8, the financial sector has been operating under highly distorted, many would say unsustainable conditions. Finding a way back to normality without triggering another collapse is as big, and as unresolved a challenge as ever it was. It is made even more difficult by the uncertainties and challenges of Brexit.

Also, figures elsewhere in the report suggest that UK regulators have not been conspicuously successful in trying to redirect the financial sector towards supporting the real economy. It is still characterized by a very powerful focus on quick returns. Not surprisingly, because they are there to take, and potentially huge. Why wait if you can have it now and have it all?

Of course, there is long term lending but mainly in the form of mortgage loans to households. If this fails to stimulate sufficient house building as in the UK, it may only serve to inflate property values and aggravate the risk of boom and bust.

As regards unsecured credit to households, at the heart of the 2007/8 boom and bust crisis, the UK regulator warns against over-lending and imposes some restrictions on payday lenders especially, but unsecured household indebtedness and the consequent financial burdens often for less advantaged households, stay worryingly high in the UK.

Turning to the quality of the ongoing service to citizens, as regards pension and investment funds the UK financial sector is characterized high fees but poor performance – by value extraction from savers in other words. The regulator has had some success in forcing greater transparency and in facilitating easier comparison between providers. Still, the persistence of high charges and poor performance shows that underlying market failure is largely unresolved.

Nor have UK regulators made sufficient progress towards equality of the sexes in City jobs, nor in restraining unjustifiably high remuneration at the top, and the impact those issues have on a sentiment of unfairness both in opportunity and in reward.

To counter-balance though, there is one big success that UK regulators can rightly claim, namely combatting mis-selling to consumers and businesses, and other poor conduct. Huge penalties have been incurred by banks in the UK amounting to £55.74 billion during the period 2010 to 2014, and a further £20 billion foreseen in the first half of 2015 – according to figures quoted in the report. This is a genuine disincentive. So far so good, although it can be regretted that very few individuals as distinct from businesses have been convicted of misconduct – there were 44 times more individual convictions in the US compared to the UK although the US market is only 5 times larger.

How does Brexit influence how all this might develop? There are two big concerns – one immediate, one perhaps less so.

The immediate concern is the risk of a disorderly exit of the UK from the EU in 16 months’ time. Could that ignite the fuse that explodes the bed of nitroglycerine?

The Bank of England recently conducted a stress test on UK banks to test the implications of a disorderly Brexit were it to happen – click here

As the above article points out, there are 6 million UK customers buying long term insurance from companies elsewhere in the EU. Also, there are 30 million rest of EU citizens who are customers of the UK financial sector. Even more importantly, the UK has issued £26 trillion of financial insurance to cover transactions in the EU. There has to be legal clarity how all this will work beyond the 29 April 2019. At present, apparently, this is still an unknown.

Second, is what happens to the volume of City trading with the rest of the EU. If EU market access is drastically reduced, the UK may seek to compensate by aggressively reinforcing the competitiveness of the City in markets elsewhere in the world, and to do that by massive deregulation. Very probably, in that scenario, consumer protection would be at risk. A transfer back to UK consumers and businesses of the penalty of mis-selling would be a considerable relief from the perspective of the financial sector.