UK's Century-Old Finance-Industry Gap Persists Despite Reforms

The United Kingdom's financial sector continues to face a longstanding challenge: its disconnect from domestic businesses. This issue, first identified nearly a century ago, persists despite numerous attempts at reform.

In 1929, the Committee on Finance and Industry, led by Hugh Macmillan, conducted a comprehensive study of British business finances. The committee, which included notable figures such as economist John Maynard Keynes and trade union leader Ernest Bevin, concluded that UK financial institutions were less supportive of domestic companies compared to their European and American counterparts. This finding, known as the "Macmillan Gap," has remained a topic of debate for decades.

Fast forward to 2024, and the situation appears remarkably similar. The number of companies listing on the London Stock Exchange has decreased significantly, and UK-listed stocks trade at a considerable discount compared to American equities. British entrepreneurs continue to voice concerns about insufficient financing for new ventures, while the country's investment track record lags behind other developed nations.

In response to these ongoing issues, the UK government and regulatory bodies have implemented various reforms. These include adjustments to pension rules, relaxed requirements for listed companies, and the reinstatement of a competitiveness mandate for financial regulators. Julia Hoggett, CEO of the London Stock Exchange, recently described these changes as "the most ambitious capital markets reform agenda anywhere in the world at the moment."

However, these reforms may not address the fundamental disconnect between Britain's financial industry and its broader economy. The UK's financial services sector accounts for approximately 12% of economic output, significantly higher than the 7% seen in the United States. London, as the world's second-largest asset management hub and leading venue for foreign exchange and over-the-counter derivatives trading, primarily caters to global clients rather than domestic businesses.

This imbalance has historical roots. As historian David Kynaston noted in his work on the Bank of England's history, the City of London has long favored international merchants and traders over domestic industrialists. This global focus has contributed to the wealth generated by the financial sector but has also led to a distortion of the domestic economy.

"We need to give retail investors more incentives to buy British stocks, reintroduce tax credits for pension funds investing in domestic equities, and abolish stamp duty on share trading."

The dominance of finance has also fostered short-term decision-making in UK equity markets. A 2011 study commissioned by the government and led by economist John Kay found that mistrust and misaligned incentives were leading firms to make poor decisions. The subsequent rise of passive index-tracking funds and private equity has further exacerbated this issue.

Recent debates have focused on the low proportion of UK stocks in British pension fund portfolios, which stood at just 4.4% in 2023. However, increasing this percentage may not necessarily lead to more support for domestic businesses. In the mid-1990s, when UK stocks comprised over half of pension fund assets, executives still complained about London fund managers' short-term focus and lack of understanding of new technologies.

While well-intentioned, the ongoing push for reform, including proposals to incentivize retail investors and mandate pension contributions, may not address the underlying structural issues. The creation of the Industrial and Commercial Finance Corporation (now 3i Group) in 1945 was a previous attempt to bridge this gap, but its impact has been limited.

As Britain continues to grapple with this century-old challenge, it remains to be seen whether future reforms can effectively align the interests of its globally-focused financial sector with the needs of domestic businesses and the broader economy.