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The Treasury’s Regulatory Dilemma: Balancing Growth and Risk in the Financial Sector
In an attempt to maintain the appeal of the City of London in the post-Brexit landscape, the Treasury appears to be overlooking a crucial insight gained from the 2008 financial crisis: lax regulation can lead to significant accumulations of risk. Recently, the Treasury initiated a consultation to evaluate the potential for easing restrictions on alternative asset managers, such as private equity and hedge funds, under the assumption that this would spur economic growth. However, the evidence supporting this stance is tenuous, and the suggested changes may, in fact, heighten systemic risks.
The proposal aligns with the viewpoint of Rachel Reeves, who advocates for the notion that expanding the financial sector could lead to increased economic prosperity. The Chancellor has expressed that regulations implemented after the crisis may have been overly stringent. These regulations included directives from the EU centered on alternative investment funds, which did not have transparent oversight prior to 2008, leaving their leverage and associated risks largely unmonitored.
Previously established EU guidelines mandated that leveraged funds managing €100 million or more adhere to rigorous reporting requirements and maintain sufficient capital to offset potential losses. Now, the Treasury is contemplating raising this threshold to £5 billion, which would exempt numerous funds from complying with the remaining EU regulations. The Financial Conduct Authority (FCA) will be responsible for determining which regulations should still apply, a move that raises concerns regarding regulatory oversight.
Reeves has directed the FCA to promote financial “risk-taking,” and the regulator has publicly noted efforts to reduce bureaucratic regulations. Such a stance appears to foster a culture of recklessness. While the market for private equity and hedge funds was previously too small to trigger a major crisis, it has expanded significantly since then, with its size having tripled. Many private equity funds have begun to leverage borrowing from shadow banks, which operate without the same regulatory constraints as traditional banks. Furthermore, some funds are taking on even more debt than normal. In 2023, the Bank of England voiced concerns regarding these hazardous practices and indicated that mainstream banks could be unknowingly exposed to the risks posed by this sector. These circumstances argue for enhanced rather than diminished oversight.
Should the FCA proceed with easing regulations, it would fulfill the desires of fund managers, who have long campaigned to dilute the EU directive since 2010. The UK was notably among the few nations to oppose the stricter rules. The government’s inclination to cater to the financial sector mirrors a belief that the City is a critical asset for the economy, a perspective that has fueled the “Singapore on Thames” vision associated with proponents of Brexit. Notably, hedge fund and private equity managers were significant donors to the leave campaign, contributing approximately £7.4 million compared to £1.25 million for the remain campaign, as demonstrated by research from academics Théo Bourgeron and Marlène Benquet.
The Treasury seems to operate under the belief that London’s financial talent could migrate to more accommodating jurisdictions like Luxembourg if it doesn’t comply with the preferences of industry leaders. However, liberalizing financial regulations could have adverse effects on economic stability. Evidence suggests that once the financial sector reaches a certain scale, it begins to stifle economic growth and productivity. A study conducted by the University of Sheffield estimated that the UK forfeited around three years of average GDP growth between 1995 and 2015 due to its oversized financial sector. Although easing regulations may benefit fund managers, the broader implications for the economy remain uncertain and more concerning.
Source
www.theguardian.com