Can reforms of financial regulation encourage economic growth?

The UK government is proposing regulatory reforms of the financial services sector as part of its agenda for boosting economic growth. The main focus is on encouraging domestic investment by pension funds and relaxing household access to credit. The chances of success are highly uncertain.

A central component of the new UK government’s economic agenda involves reforms of domestic financial regulation to encourage growth. The proposed changes are part of a broader financial services growth and competitiveness strategy to revive the country’s financial services sector, a component of the new industrial strategy. They also reflect a wider move by the government to encourage regulators to liberalise rulebooks in order to deliver growth.

Unlike in other sectors, in financial services, deregulation to deliver growth was started by the previous government through its Edinburgh reforms. Under these measures, the industry regulator – the Financial Conduct Authority (FCA) – has already been assigned a ‘secondary objective’ to its primary one of ensuring that financial markets work well: namely, facilitating the international competitiveness and growth of the economy.

In this article, we examine the two main pillars of financial services reform within this strategy: increasing domestic business investment through reform of rules relating to how pension funds and consumer savings are invested; and increasing consumer demand through relaxing the supply of credit to households.

Encouraging pension fund investment in the UK

A first element of reform of UK pension funds is the creation of larger pension schemes, which can take advantage of economies of scale. In a series of measures including a forthcoming pensions schemes bill to be put to parliament, the government is seeking to create what are referred to as pension ‘megafunds’ – for example, by pooling local government pension schemes (of which there are currently 86 in the UK) into fewer, larger funds.

The new megafunds will be required to specify a target for the pool’s investment in their local economy, working in partnership with local and mayoral combined authorities to identify the best opportunities for supporting local growth. The government hopes that this could increase local investment in the UK by £20 billion, and total UK investment by £80 billion.

A second element of this reform is to encourage households to put more of their savings at risk by buying investments, such as equities listed in the FTSE100 index. Many individuals with investible financial assets choose to hold them mostly or wholly in cash.

The FCA estimates that 11.8 million consumers in the UK have £10,000 or more of investible assets, yet hold the majority or all of these assets in cash. Survey evidence suggests that of these, 44% (5.2 million) have some appetite to take investment risks (Financial Lives Survey, 2023).

The FCA is targeting this problem in its Consumer Investments Strategy. In particular, it is seeking to amend rules relating to how investments are described and how their risks and returns are illustrated, to encourage more consumers to buy investments.

There have been suggestions that government policy should go further, potentially mandating investment in the UK for investors seeking to take advantage of tax-preferred savings such as individual savings accounts (ISAs) and self-invested personal pensions.

Will it succeed?

While these reforms may indicate a desire on the part of the government for UK pensions funds to invest more domestically, the decision to do so ultimately lies with the trustees of the pension funds.

Pension fund trustees have a fiduciary duty to seek the best outcome for their members (who are typically employees of firms paying into the fund). Currently, trustees seem somewhat equivocal about the proposed reforms, with Vassos Vassou, vice-chair of the Association of Professional Pension Trustees quoted in the Financial Times saying: ‘As trustees we are always looking for products that will provide higher long-term returns for our members – if the UK economy can give us such a product then we will invest in it for our members’.

Further, finance theory suggests that trustees should look away from the UK when scoping where to invest in order to improve diversification. The employees over whose money trustees make investment decisions are employed in the UK, and the prospects for their jobs and real incomes are dependent on the fortunes of the UK economy. Investing pension funds in the UK implies that investment returns on their pensions would also be dependent on the fortunes of the UK economy.

Arguably, these funds should overweight their investment internationally, diversifying away from domestic risks. This applies equally to consumers choosing where to invest their money: diversification points consumers away from the UK as a place to invest, weighting purchases of equities and mutual funds to overseas stocks and shares.

Relaxing the supply of credit to households

The second major component of the financial services and growth strategy is a relaxation of the rules governing the supply of credit to households. This is a significant change of direction for the government – and for the FCA in its oversight of consumer lending. The regulatory regime introduced with the creation of the FCA in 2014 has steered mortgage and unsecured credit lenders towards more cautious lending rules, curtailing riskier lending.

New rules on affordability and creditworthiness placed obligations on lenders to stress-test the ability of consumers to make loan repayments. In many cases, this rendered them ineligible for loans for which they might previously have been eligible based on their income and expenditure.

The introduction of limits on loan-to-income ratios put in place by the Prudential Regulation Authority (PRA) limited the ability of lenders to issue large mortgages to households hoping to borrow an amount equivalent to many times their incomes.

The introduction of these rules has been associated with a rapid decline in household debt in the UK. Prior to the global financial crisis of 2007-09, the UK economy had strong consumer spending growth, a low saving rate and steady increases in household debt in order to finance all that spending.

Low global interest rates spurred growth in the value of houses and shares, increasing household wealth and further stimulating consumption. This resulted in a rapid increase in the household debt-to-income ratio, as illustrated in Figure 1.

But since the global financial crisis, this ratio has steadily fallen, its decline further accelerated by a period of high inflation resulting in large increases in nominal incomes (further reducing the ratio).

Figure 1: UK household debt-to-income ratio, 1987-2024

Source: UK Economic Accounts (UKEA)

It is hoped that the relaxation of these rules will allow consumers to borrow to fund consumption – of both housing and non-housing – thereby increasing growth. Consumption (usually defined as people paying for goods and services) is the largest single component of GDP in the UK – and yet, over the past decade, it has hardly grown.

Increased mortgage lending would also contribute to demand for housing, which is important if the government is to meet its declared ambitions for house-building. Developers will only build new houses if they expect households to be able and willing to purchase them.

Relaxation in mortgage lending rules might also encourage households to borrow more against their homes. Individuals over-mortgaging or remortgaging to extract money from their home is known as housing equity withdrawal.

Prior to the global financial crisis, housing equity withdrawal was a significant stimulant of consumer spending. But in the post-crisis period, it has been negative, which means that UK households have, on average, been paying down their levels of mortgage debt.

Figure 2: Housing equity withdrawal (% post-tax income), 1970–2024

Source: Bank of England

Will it succeed?

As with the reforms of pension fund investment, success is dependent on individuals and households taking the opportunities provided by the reform. In the case of relaxing the supply of credit to households, this will only have an effect on consumption if consumers choose to borrow more. The premise of this regulatory reform agenda is that consumers would react to deregulation by taking up new opportunities to borrow.

Consumer confidence data suggest that, in reality, the average UK consumer may not be keen to extend their borrowing. Consumer confidence remains weak. The long-running GfK Consumer Confidence Index continues to show overall confidence is low (and has been since the Brexit vote in 2016) – and it has declined since the new government came to power in mid-2024.

Consumer confidence is important because choices about borrowing are predicated on expectations of the future, according to a fundamental insight from consumer theory.

Today’s borrowing to finance consumer spending is tomorrow’s debt to repay, and if tomorrow doesn’t look so rosy due to high inflation, declining real wages, higher interest rates, weak productivity growth and declining international competitiveness, then consumers might take a more cautious approach.

Where can I find out more?

Financial Services Growth and Competitiveness Strategy.
Financial Services: The Edinburgh Reforms.
Chancellor fires up financial services sector to drive growth: UK government press release, November 2024.