Could the UK's Net Zero Commitments Undermine Financial Stability?

The 2008 Great Financial Crisis (GFC) dealt a hammer blow to ‘light touch’ financial regulation and in the UK led to a complete overhaul of its financial regulators with the Financial Services Authority (FSA) being abolished in 2013 and being replaced by a ‘twin peaks’ system of regulation with the newly created Financial Conduct Authority (FCA) being responsible the regulation of retail and wholesale financial services firms and the Prudential Authority (PRA) having responsibility for banks, insurers and major investment firms. Coordinating the activities of both regulators was the the newly established Financial Policy Committee chaired by the governor of the Bank of England.

Following the UK’s official exit from the EU in 2020, a full review of financial regulation rules was undertaken in order to formally incorporate or revoke legacy EU laws and the results of this review were incorporated into the 2023 Financial Services and Markets Act (FSMA). The Act proposed sweeping reforms to the regulation of the UK’s financial services sector including the introduction of secondary objectives for the FCA and PRA requiring them to focus on the international competitiveness of the UK financial services market and harmonise financial regulation with the governments medium to long-term economic goals.

There was considerable cross-party political support during the passage of the FSMA through parliament particularly in respect of regulatory reforms that had the potential to unlock large amounts of previously unavailable capital from regulated firms that could be invested in ‘productive assets’. The Chancellor of the Exchequer, Jeremy Hunt, stated that reforms to insurance regulation (Solvency II) could provide an additional £100bn of additional investment over the next 10 years, much of which would boost ‘green and good’ projects helping the UK meet its ambitious net zero targets.

The deterioration of the global economy since 2020 has dampened the government’s rhetoric, if not their plans to de-regulate UK financial services post-Brexit. In 2021 then Chancellor, Rishi Sunak coined the phrase ‘Big Bang 2.0’ to emphasize the opportunities he felt were then available to the UK by creating a ‘smarter’ more agile financial services framework. As the global economic situation worsened following Russia’s invasion of Ukraine and risks in the global financial system mounted, a more sober range of regulatory reforms were announced in Edinburgh in 2022 and these form the basis of the 2023 FSMA.

With global interest rates at elevated levels, stretched stock market valuations in the US and unbalanced housing markets in the UK and the US together with a combination of geo-political problems, the risk of a global financial crisis developing is greater in 2024 than at any time since the GFC. Many would argue that for all of the perceived benefits of liberalising financial regulation, as outlined in the FSMA , now is not the time to do so. Even though the GFC took place fifteen years ago, Central Bank balance sheets remain swollen as a result of post-GFC quantitative easing programmes and UK bond markets remain fragile as demonstrated in 2022 when Kwasi Kwarteng’s tax cutting ‘growth’ mini-budget caused a surge in bond yields crashing the value of sterling and setting off the LDI crisis in the pensions market.

Globally, the biggest current threat to financial stability comes from shadow banks or, as they are now less pejoratively known, non-bank financial intermediaries (NBFI). NBFI’s include private credit and equity funds, hedge funds, insurance companies and pension funds which carry out various bank like activities but remain outside of the scope of mainstream finance regulation.

NBFI’s have thrived since the GFC taking advantage of regulatory arbitrage opportunities created as mainstream banks were forced to become more risk averse due to their need to maintain higher capital requirements. Private market NBFI’s now hold 50% of all financial assets in the US and UK and are generally considered to add to the efficiency of financial markets allowing smaller businesses access to capital that mainstream banks no longer provide due to regulatory constraints.

In response to threats posed to the financial system by rises in global interest rates, finance regulators and central banks are now focusing on the NBFI sector as a potential catalyst for financial stability problems. NBFI’s are not subject to the strict capital requirements of mainstream banks and do not have access to central bank liquidity or public sector credit guarantees which makes them inherently fragile. Many NBFI’s also use leverage to enhance their exposure to investments and this borrowing is often sourced from mainstream banks thus providing a conduit for the transmission of risk to the wider financial market. Initial findings from a thematic review of bank lending to the private equity industry by the PRA (May 2024) found that in many cases banks were unable to assess their counterparty risk to PE clients due to an inability to aggregate their upstream and downstream lending exposure to an individual fund.

The UK’s formal exit from the EU in 2020 necessitated a thorough review of its financial services regulatory framework in order to formally incorporate or cancel legacy EU rules. Beyond this it gave the government the opportunity to align financial regulation to its long term goal of harnessing private investment to help fund its net zero commitments and to ensure that the UK financial services sector remained internationally attractive post-brexit. The present government has made no secret of its desire to innovatively de-regulate the UK’s financial services sector and given the Labour party’s equally strong commitment to combating climate change the current trajectory for financial service regulation as laid out in the 2023 FSMA will remain in force.

In 2011 the Treasury, in a review of the factors that led to the GFC, made the following observation:

‘’ the Government considers that the case for making global competitiveness and innovation in financial services part of the responsibility of a regulator charged with ensuring the safety and soundness of risk-taking financial firms needs to be reconsidered. There is a strong argument that one of the reasons for regulatory failure leading up to the crisis was excessive concern for competitiveness leading to a generalised acceptance of a ‘light-touch’ orthodoxy, and that lack of sufficient consideration or understanding of the impact of complex new financial transactions and products was facilitated by the view that financial innovation should be supported at all costs.’’

With the challenges posed by rising competition from Asian financial centres and the growing dominance of US public equity and debt capital markets the temptation to ‘turbocharge’ the international competitiveness of the UK’s financial services sector is strong. Doing so by adopting light-touch regulation only invites history to repeat itself.