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Regardless of ideological parti pris, politicians have an uncanny knack of misconstruing the dynamics of the financial services sector as they seek to bend it to their cause. Consider, first, UK Labour chancellor Rachel Reeves who, like her Tory predecessor Jeremy Hunt, wants more growth-friendly financial regulation, a demand widely echoed by policymakers around the world.
Reeves and Hunt have also urged UK pension funds to allocate more capital to growth opportunities in domestic private markets. Both join in the global hand-wringing over the pervasive decline in the number of initial public offerings in public equity markets.
No matter that long experience tells us diluting financial regulation is potentially a recipe for systemic chaos. Nor that governments muscling in on pension fund asset allocation is fraught with danger. Let’s just start with the gross misunderstanding of the financial system revealed by the politicians’ worries about shrinking IPOs.
In the good old days, stock exchanges were great national institutions. IPOs were a time-honoured step in developing a business and raising new capital for investment. That paradigm has gone the way of the telephone directory, fax machines and cassette tapes.
Developed-world equity markets have not been an important source of finance for years. As John Kay pointed out in his review of UK equity markets back in 2012, equity markets should be seen primarily as a means of getting money out of companies rather than putting it in. That is, they facilitate an exit for financial backers of fledgling companies.
Despite the relative shrinkage of public markets, access to capital is scarcely a concern because private markets have ballooned. With abundant access to private capital, there is no compelling reason for them to go public other than to satisfy financial backers and shareholders.
The decline in IPOs is, in fact, a global phenomenon reflecting the lower capital intensity of advanced, knowledge-based economies. Meanwhile, the political concern in London over the loss of IPO market share to New York should be seen for what it is: atavistic mercantilism, which has little real bearing on UK productivity. And the much noted weakness of the UK productivity sector is not primarily down to choices of where to list or of capital market structure.
What does matter for productivity, politicians should note, is that the central role of primary equity markets for new shares is to raise capital for companies that are already quoted. In the US, the UK and other leading economies, growth is heavily debt-financed and public debt is running at close to wartime levels. The equity market is crucial in providing fresh capital to bolster corporate solvency and facilitate deleveraging when the economy is hit by the periodic financial crises that tend to follow financial deregulation.
That said, politicians are not entirely wrong-headed in wanting pension funds to immerse themselves in private markets. This is where much innovation in areas such as biotech, climate change and artificial intelligence is taking place. The supposed snag is that private shares are illiquid, meaning difficult to buy and sell. Yet defined contribution pension scheme members have no need of liquidity until retirement looms. Exposure to domestic private equity also offers them valuable diversification from investment in passive equity funds that suffer from excessive concentration in US equities and especially Big Tech.
Yet from a broader economic perspective, the opacity of private markets carries the risk of capital misallocation. Performance figures are misleading because of the huge windfall of returns garnered by private equity on investments funded with the freakishly low interest rates after the financial crisis that have now disappeared. In the hangover from the boom, private equity managers are struggling to sell companies and return cash to investors.
Much stop-gap financing is today being provided to them by private credit. According to economists Leonore Palladino and Harrison Karlewicz, fast-growing private credit funds pose a unique set of potential systemic risks because of their reliance on bank funding, loan illiquidity, the opacity of the terms of loans and potential maturity mismatches with investors’ needs to withdraw funds. Importantly, this market has never been tested in a downturn.
The lesson politicians must learn is that the productive contribution to the economy of a well-functioning banking system is the accurate pricing of credit and liquidity risk. We know from the financial crisis, which followed years of mispricing of risk, that our debt-laden economy is forever hostage to excessive risk taking in finance. So a central goal of policymakers should be to minimise this hugely economically costly systemic vulnerability and to treat with extreme caution the pleas of bankers and business lobbies for light-touch, supposedly growth-friendly, regulation. The benefits here for taxpayers, investors and savers are far greater than anything that will come from politicians playing with other people’s pension fund portfolios.
john.plender@ft.com
