Submission from New Capital Consensus to the Business and Trade Committee Inquiry into Financing the Real Economy

Introduction

New Capital Consensus (NCC) is a coalition of not-for-profit, apolitical organisations that have come together to explore how the UK’s investment system currently contributes to the country’s low productivity, inequality and low levels of investment. We are incubated by the Chatham House Sustainability Accelerator, and our partner organisations include Radix Big Tent, the University of Leeds and the Financial Systems Thinking Innovation Centre (FinSTIC).

Over the past two years, we have worked collaboratively with academia, industry leaders and parliamentarians to identify the systemic reforms required to connect purposeful capital to societal goals, unlocking investment to boost outcomes for savers and society - such as powering up the housing sector to solve issues around housing supply - and meeting the Government's growth targets.

We are responding to the Committee’s call for evidence as we believe that examining the financing of the real economy is central to improving the growth prospects of the UK and redesigning the financial system to work for savers and society. 

The UK is currently grappling with historic levels of under-investment, reflected in the poor state of much of its social and physical infrastructure, ranging from transport and water, health and technology. The primary source of UK economic investment is the savings of the nation’s population. It is ordinary savers that own businesses either directly or, more often, through their retirement and investment funds, which then use investment managers to invest via a wide range of investment instruments and vehicles. 

80% of UK investment derives from the private sector while the UK enjoys the second largest pool of retirement assets amongst OECD countries. Despite this, business investment is one of the lowest among OECD countries, while the UK is producing suboptimal returns for savers leading to reduced financial resilience and poorer lives in retirement.

Is British investment too low—and why? 

New Capital Consensus believes that the sector requires redesign in order to create a system of purposeful investment that produces better outcomes for both savers and society.

The research outlined in our recent paper, The Trillion Pound Question, has shown that trillions of pounds in investment capital from DC and DB pension schemes are being fettered by ‘safetyism’ baked into the system that prevents capital from being invested into productive assets that benefit the UK economy. 

New Capital Consensus’ research found that the UK enjoys the 2nd largest pool of retirement capital amongst OECD countries. And yet, despite such a large pool of capital sitting in occupational pensions, the rate of business investment in the UK is one of the lowest among OECD countries.

As systems-thinkers, New Capital Consensus believes that there are a number of issues within the investment chain from savers to businesses that hamper productive investment. These include the way the system measures and regulates long and short-term risk, encourages less-productive secondary investment at the expense of primary investment in growth businesses, and lacks incentives to prevent asset allocators moving capital to unproductive passive indexes - such as the MSCI Global Index which allows managers to invest more of pensioners’ money in Amazon than in their national economy. 

Some recent initiatives from both the Chancellor and the Pensions Minister to change the way that the system operates through the Leeds Reforms and the Pension Schemes Bill - pooling smaller DB funds into superfunds to invest at scale for example - are very welcome. 

But New Capital Consensus believes that these reforms are only the first step towards redesigning a system that has the potential to both redress the social contract between savers and society and deliver the boost in investment that the real economy requires. 

If the issue is not the amount of investment capital available in the UK, then what is it? 

New Capital Consensus believes that the systemic issue of entrenched capital pooling in unproductive assets is down to the suppliers and allocators of investment capital - which we will address in the following section. 

The suppliers of capital

• Do UK institutional investors allocate sufficient capital to productive enterprise—and if not, what are the underlying reasons? 

The UK’s current regulatory architecture is complex, complicated and patchwork. This means that however well-intentioned individual policy interventions may have been over time, in aggregate the UK regulatory system is now delivering unintended and unwelcome consequences for savings and investment in the UK.

Based on approximately 45 ‘Chatham House Rule’ interviews with participants across the system New Capital Consensus has generated a picture of the UK investment system as it is in reality (‘warts and all’), rather than as it should operate according to Efficient Market Theory or other academic / ‘rational’ models of economic and human behaviour.

While market participants and regulators continue to look to traditional financial economic theory for their models, in reality, the UK investment system is a classic “complex adaptive system” and like most systems (from corporations to ecosystems) is therefore not the product of conscious design – or rather, is the product of nondesign.

The UK investment system has ‘emerged’ over time out of the networked actions of different and seemingly unrelated system actors, all of whose independent actions, logics and interests roll up into a systemic ‘interdependence’ whose whole is greater than the sum of its parts.

Each system actor, in turn, develops his own behaviours and establishes his own ‘mindsets’ by responding to incentives, and by learning from ‘feedback loops’ that either stabilise, dampen or amplify each element of this behaviour.

The UK investment system has thus evolved rather than consciously developed, and continues to evolve from the myriad interdependent actions of otherwise independent participants – from employer-sponsors, pensioners and savers, through legislators, regulators and industry players to the press and other stakeholders.

Almost without exception, interviewees described with frustration how they were obliged to conduct their business in ways which, whilst profitable for their shareholders, are sub-optimal for their clients or clients of their clients. Many interviewees felt powerless to bring about beneficial change and welcomed the interview as an opportunity to share suggestions which could be of benefit to all. 

Key issues identified from market actors included:

• Inadequate or sub-optimal outcomes for savers. Much of this sprung from sub-optimal risk-bearing and lack of long-termism within the system. The inappropriateness of regulatory, accounting and actuarial risk measurement was a constant refrain. There was a general recognition of the system’s failure to support the UK economy, with ambiguity over whether current investment approaches are genuinely in savers’ wider interests.
  
  
• Constraints and lack of agency in investment mandates. Much frustration was also derived from channel interfaces. For example, Fund and Portfolio Managers were frustrated by the lack of long-termism and ‘strategy’ in the investment mandates provided to them by Asset Owners, who in turn struggled with regulatory and other constraints around the construction of strategic asset allocation. The lack of scale of many Asset Owners has led to clients with insufficient agency, skills and knowledge, so we were told.
  
  
• Liquidity overemphasis in system behaviors. Whilst regulation, accounting and tax were identified as powerful drivers of behaviour, risk management, the role of employers and market practices were also identified as key, with the latter playing an important part in the system’s over-emphasis on liquidity and daily pricing.
  
  
• Absent incentives to generate returns for savers. Of equal importance, we were told, was the lack of incentives to generate returns for savers, with ‘low cost’ and ‘safetyism’ dominating. The incentives to close industry gaps in service (for example, affordable advice/guidance, decumulation solutions, etc.) are weak, as are those required to provide Private Equity transparency. The system is lacking sufficient incentives to support innovation and creativity, primary requirements for growth.
  
  

• An over-focus on cost in workplace DC (partly driven by employer and saver preferences) and in Retail/Private investment has led to both a passive mindset and helped to drive consolidation within the asset management industry. The markets and regulatory focus on ‘low cost’ has undermined the proper emphasis on performance and outcomes. Global approaches to asset allocation, adopted by larger Asset Managers, have reduced investment in the UK economy, in turn diminishing the UK share in global indices. Indeed it is now the case that investing in the MSCI Global Index as a manager will invest more capital in Amazon than it will to the UK economy as a whole. 

• Industry approaches to ‘relative’ benchmarking and diversification-seeking further drive the adoption of global indices in setting pension scheme allocation, which reduces investment into the UK. Because global indices are dominated by US companies (and increasingly by US tech companies) UK investment is effectively supporting the US tech / growth agenda rather than the same within the UK.
  
  
• A system-wide focus on short-term volatility over long-term risks has contributed to risk-reward aversion among a wide range of stakeholders which in conjunction with regulatory safetyism has created a market driven to minimise risk rather than to find the appropriate trade-off between risk and reward/return.
  
  

  What constraints do pension funds, insurance companies, and sovereign wealth funds face when investing in UK growth assets?

Low-cost, short-term, passive, secondary investment mindsets are promulgated through the construction of investment mandates. To counteract this, we need to re-incentivise return-seeking, to counteract the dynamics currently driving low-cost investment, and reduce short-termism by requiring investment mandates to reflect the duration of savers actual requirements for access to their investments; this latter requires reducing the incentives behind liquidity-seeking.

The approach to solvency requirements for DB Superfunds creates a straightjacket that limits DB superfunds from investing in UK growth assets; such funds are construed as insurance companies. In order to capture the growth potential of these funds and to secure productive investment at scale, they must be regulated as pension funds outside of a Solvency ringfence.

Remove the requirement for daily liquidity in the DC and Private / Retail Investment markets – on the grounds that the benefits of daily dealing (immediate subscription / redemption) are increasingly outweighed by the cost that a daily liquidity mindset brings to asset allocation, and the inhibiting effect on primary investment in real assets.

The system’s risk culture also prevents investment flexibility and long-term value generation due to its unhealthy focus on volatility and liquidity risk at the expense of duration risk and risk to returns. New Capital Consensus would argue that there is risk inherent in allowing huge pools of capital to stagnate in unproductive areas whilst the UK economy, infrastructure and energy transition suffers.

The UK Government must change the system risk culture by revisiting regulatory and industry risk measures to free up investment strategies and support institutional risk-sharing with clients – beginning with the system’s current unhealthy focus on volatility and liquidity risk at the expense of duration risk and risk to returns.

DB schemes should be given greater investment flexibility and DC schemes should be encouraged to seek performance rather than low cost through extending the planned Value for Money regime and by updating the guidance to employers on the choice of a suitable DC default fund for their workplace scheme. 

Mechanisms also need to be introduced to support pensions schemes ‘run-on’ strategies – to extend investment durations and reduce unhealthy derisking. This has the potential to deliver a win-win-win for the UK: improved profits for businesses; improved products and services for consumers (as well as innovative solutions for the environment and society); and improved investment returns for pensioners.

• How does the UK’s financial infrastructure—including equity and debt markets—support or hinder productive investment?

The source of greater UK productivity is in more primary investment into UK growth businesses, especially those that creates products and services needed by UK consumers and creates jobs for UK residents. Currently, the financial system incentivises short-term, low-cost, passive secondary investment that is not in-itself productive. The way risk appetites are developed for UK insurers and pension funds needs to be revisited to reflect the underlying ability of these institutions to invest long-term an d provide risk bearing capital to UK companies.

• How do UK tax policies, regulatory frameworks, and risk management practices influence investor behaviour and capital allocation?

The Government must change tax incentives/disincentives to operate at the asset level as well as at wrapper level – to boost the appeal of productive UK investment and to put equity investment on a par with debt investment. Savers are rightly given incentives to invest, but not to invest in the UK, to support the communities in which they live and will most likely retire. Re-establishing the social contract between society and savers is an appropriate quid pro quo for the valuable tax incentives provided.

Change is also needed to create the right regulatory incentives for a sustainable growth economy.. The current system is only a decade old but was designed to address problems caused by the Global Financial crisis, not the challenges of the next two decades.

The industry is already suffering regulatory fatigue so changes will need careful management to achieve buy-in. In the interim, change to regulatory oversight is essential - it is unreasonable to expect regulators to set the rules and also assess the effectiveness of the rules they have themselves imposed on others. The fragmented and over-complex regulatory system also needs redesign at an architectural level.

The current regulatory architecture is itself over-complicated, fragmented and lacks accountability against system purpose.

• Short term, we recommend extending the role of the Regulatory Innovation Office to have responsibility for system oversight measured against system purpose – beginning with a system purpose that delivers on social goals for individuals, the economy and society; while recognising
  
  
• Longer term, we recommend review of the regulatory architecture and its modus operandi; a rebalancing the role of regulators to create the right tradeoff between the achievement of savers’ objectives, the security of institutions, democratic parliamentary accountability and a rationalising and modernising of the regulatory approach.
  
  

The end result of these recommendations could be transformative:

• A more resilient UK economy and sovereign state;
  
  
• Better retirements because of bigger investment pots;
  
  
• More UK investment to provide the capital needed to develop green infrastructure for sustainable growth; and a growing economy, providing better, more productive jobs.