In its desire to ensure the City of London remains attractive after Brexit, the Treasury seems to have forgotten one of the major lessons of the 2008 financial crisis: when regulation is lax, risks accumulate. This month, it launched a consultation about whether it was time to lighten the rules governing alternative asset managers, including private equity and hedge funds, in the belief that doing so will boost growth. There is little evidence to support this idea, and every reason to think it could exacerbate systemic risks.
The proposal is consistent with Rachel Reeves’s belief that expanding the financial sector will deliver economic prosperity. The chancellor has suggested that post-crisis regulations went “too far”. Those regulations included an EU directive targeting alternative investment funds. Before 2008, these funds operated mostly in the dark. There was no means of systematically tracking the leverage they were using, nor the dangers this might pose.
Under the EU rules, leveraged funds managing €100m or more in assets had to comply with strict reporting requirements and hold enough capital to absorb losses. The Treasury is now considering lifting that €100m threshold to £5bn, which would exempt many funds from the full list of EU rules. It will fall to the Financial Conduct Authority to decide which rules to apply. This is troubling.
Ms Reeves has instructed the FCA to encourage financial “risk-taking”, and the regulator has boasted about slashing “red tape”. Both sound like recipes for recklessness. Though the marketplace for private equity and hedge funds was too small to cause a crisis back in 2008, it has since tripled in size. Many private equity funds have started borrowing from shadow banks, which aren’t subject to the same regulations or capital requirements as normal banks. Others have begun taking on even more debt than usual. The Bank of England raised the alarm about these risky practices in 2023, and has suggested that mainstream banks may be unwittingly exposed to the industry. These are reasons for more oversight, not less.
If the FCA loosens the rules, fund managers will have got their way. They lobbied to have the EU directive watered down in 2010, and the UK was one of the few countries to oppose the rules. Then, as now, the government wanted to protect the City, believing it to be a goose that lays golden eggs. This antipathy towards financial regulation was a prelude to the “Singapore on Thames” worldview promoted by Brexiters. Hedge fund and private equity managers donated lavishly to their cause. A study of Electoral Commission data by the academics Théo Bourgeron and Marlène Benquet revealed that these fund managers donated nearly £7.4m to the leave campaign, and just £1.25m to remain.
The Treasury seems to think that unless the City gets what it wants, Britain may lose its fund managers to countries such as Luxembourg. There are many reasons to be wary of liberalising finance. One is that it will hinder, rather than help, economic growth. Research suggests that once the sector exceeds a certain size, it starts to become a drag on growth and productivity. A study from the University of Sheffield found that the UK lost out on roughly three years of average GDP growth between 1995 and 2015 thanks to its bloated financial sector. Watering down regulations might be helpful for fund managers. It is hard to see who else would benefit.
