A fast and low-risk solution to the growth problem?

Small innovative companies face a significant equity shortfall. If this shortfall could be reduced substantially, these companies would materially increase national productivity and growth. But the regulations which contributed to the shortfall are well-founded. Simply reducing or reversing these regulations would likely impose high social costs. The regulations are diverse and from different sources. Collectively, they impact upon all significant pools of equity that might be available to growth companies. We explore whether the regulations can be modified at an acceptable risk to increase growth materially. We also discuss an alternative scheme that could more immediately divert substantial equity back to growth companies.

Introduction

In our recent analysis of the European growth problem, we identified regulations which reduced the flow of capital to growth companies. We demonstrated that innovative UK growth companies face an equity shortfall.¹ This shortfall means that many innovative companies cannot bring their ideas to market or expand. Such companies can be significant contributors to improved productivity and growth.² Therefore, enabling them to gather more equity should reduce the growth problem.

However, the regulations which reduced the flow of capital from the pools on which growth companies could formerly draw likely produced material benefits. For example, banks and insurers with less-risky balance sheets reduce the probability and scale of costly financial crises. Similarly, defined benefit pension schemes with limited equity exposure have a lower risk of inability to pay pensions when these fall due.³ Again, UK retail investors now invest far less in equities than they used to,⁴ likely reflecting stiff regulatory risk warnings⁵ and conduct regulation, which give protection from harmful negative shocks.⁶

Listing rules could stop growth companies from making UK IPOs. But where there is reduced demand for equity, an IPO may fail. As some UK firms make US IPOs under tough rules, UK demand for equity is likely the bigger issue. Therefore, it is unlikely that amending listing rules could be a major contributor to reducing the equity shortfall.

Another pool of equity for growth companies is large companies, especially those operating in a related field. Such investment is less subject to adverse selection and benefits from the investors’ skills and networks, which boosts growth. Nevertheless, this pool of equity is increasingly off limits—due to competition authorities’ concerns about acquisitions⁷ increasing market power and thereby reducing innovation and growth. It is beyond our scope to discuss the Schumpeterian arguments for large corporations being central to innovation (due to the need in technological eras for large-scale units of control) and Arrow’s arguments against this, in particular that intense competition fosters innovation.⁸ However, we flag this issue as it shows the breadth of the challenge facing policymakers: which of today’s large companies are like multiple Nobel Prize-winning Bell Labs,⁹ and which bear out Hicks’s observation that ‘the best of all monopoly profits is a quiet life’?¹⁰

The challenges

Can changes be made to the financial regulations outlined above so that substantial flows of equity to growth companies can resume without undue risk and costs arising? Our recent article argued that the Financial Policy Committee could usefully consider this, given the trade-offs involved and the system-level problem of co-ordination of regulation and its cumulative impacts. These may not be salient for individual regulators focused on meeting their objectives. Even ignoring listing rules and competition enforcement, the trade-offs involve bank regulation, insurance company regulation, accounting standards, guidance to trustees from The Pensions Regulator, and various aspects of retail conduct regulation. Preparing a combined, ex post, cost–benefit analysis of relaxing some or all of this would be difficult, although the thinking involved could yield important insights. It would also be a lengthy process, and lack of growth is a pressing issue.

Here, we seek to identify which pools of capital are best left undisturbed—as the balance of costs and benefits arising from changing financial regulation is unclear or obviously negative—and whether any pool could sensibly be re-deployed quickly in growth companies. We look in turn at each relevant pool of capital.

Diverting ‘regulated’ capital to growth companies at scale without changing regulation is a separate challenge: could this be done without materially increasing systemic or consumer risks? We explore a scheme that may be able to boost growth materially and quickly without jeopardising the goals of regulation.

There is a separate and valid case for general regulatory reform—for example, lowering compliance costs and administrative burdens is important, and we note that the PRA and FCA are both acting to achieve this—however, such reforms are unlikely to liberate the capital needed to boost growth materially in the timescale required.

Bank regulation

Since the Global Financial Crisis (GFC) of 2008, bank regulators have analysed the costs of the crisis and the costs of the measures taken to make future crises less likely and less costly. The sums involved were significant,¹¹ including for the UK,¹² and they continue to be substantial even in the latter stages of the Basel 3 reforms.¹³ Moreover, a material change in the UK’s growth and productivity requires a diversion of billions of pounds from low-risk investments to growth companies.. While in the medium term this will likely earn net higher returns for the asset owners, banks are ‘fragile by design’ and vulnerable to short-term declines in asset values.¹⁴ Since venture capital and scale-up equity are volatile assets, we conclude that the expected costs of a material diminution in prudential standards for banks (i.e. tolerance of substantial amounts of volatile investment by banks) could be very high, unless, and only to the extent that, a ‘non-systemic’ subset of banks can be identified.¹⁵ We also note that financial stability is itself important for growth,¹⁶ that sustainable growth helps financial stability (too little or too much growth damages stability),¹⁷ and that a substantially expanded financial sector would not necessarily help growth.¹⁸ We therefore suggest that a solution to the problem of productivity and growth be (largely) sought in places other than relaxed capital standards for banks.

We emphasise that we do not argue that no reforms to bank regulation are warranted. This is an empirical question. Authorities should consider carefully whether the UK’s position justifies significant requirements beyond the internationally agreed regime or its calibration in other sophisticated jurisdictions. Again, however, it is not clear to us that such reforms would liberate the billions of pounds of capital needed to drive a material change in the UK’s rate of growth.

Insurance company regulation

As in the case of banks, much has been done to strengthen the prudential requirements applicable to insurers since the GFC of 2008. This culminated in Solvency II, which was implemented in the UK in 2016 and, exploiting legal freedom from EU standards, replaced with a rigorous regime tailored for the UK in 2024.¹⁹ For the costs of diluting this regime to be comparable with the benefits of higher growth across the economy, the regime likely needs to reduce systemic risk. While the evidence for this is less obvious than it is for banks, the insurer AIG was a material player in the GFC,²⁰ and there is widespread acceptance that insurers can pose systemic risk.²¹ We therefore conclude that diluting insurance regulation would involve significant risk, implying that capital for growth might best be sought elsewhere.

Regulation to protect retail investors using ISAs, Defined Contribution pension schemes, OIECS, etc.

On the positive side, altering regulation to motivate shifting consumers’ portfolios from the conservative portfolios currently held²² toward growth companies could allow consumers to gain enough capital to retire, or reach other financial goals, as well as providing equity for growth companies. Conversely, the likely effectiveness of such measures in the case of investment in growth companies, their likely speed of impact and consequential costs do need careful consideration.

Regarding likely effectiveness, Oxera’s report for TISA,²³ shows that a high proportion of consumers do not even consider equity investment, while consumer financial literacy and the regulated consumer journey towards equity investment are both barriers. The report finds that most consumers drop out of the journey before reaching the ‘action’ stage. It suggests six steps that could help consumers invest in equity, such as correcting beliefs about the likelihood of loss.

Our concern here is not with equity investment in general, but with a risky subset of equity. Oxera’s research for the report cited above found that ‘[t]he main barrier appears to be the perceived riskiness of S&S (stocks and shares) ISAs’.²⁴ Despite this, the FCA found that ‘[c]ryptocurrency is seen as more exciting than S&S ISAs’, which indicates a further impediment to diverting retail investors’ funds into growth stocks.²⁵ The increasing allure of meme stocks also needs consideration,²⁶ and further evidences behavioural bias in investing. Generally, we note the literature in behavioural economics on the difficulty of de-biasing consumers, starting from a well-known paper which introduced the ‘curse of de-biasing’.²⁷ We therefore doubt that lightening the regulated consumer journey would channel the required volume of funds into equity investment in growth companies, at least not quickly, given the widespread change in beliefs, biases and culture needed. As Morningstar states, ‘[t]he cognitive biases we face when investing today have been with humans for millennia, so they won’t be going anywhere anytime soon’.

We also note that financial regulation encouraging consumers to invest in unlisted shares in small companies could bring material costs. UK financial regulation started with the Norton Warburg scandal of the early 1980s, and progressed through incidents of mass redress such as pension transfers, mortgage endowments, PPI and interest rate swaps to current issues such as motor finance. There are always some vulnerable consumers and a fringe of bad actors to exploit them. Indeed, in his speech to the ABI on 27 February 2025, FCA Chief Executive Nikhil Rathi referred to motor finance, general insurance pricing and COVID-19 business interruption insurance in lamenting the negative impacts of major claims and redress events.²⁸

Mr Rathi also wrote to the UK government on 16 January 2025 that if regulation is loosened, the government will need to accept the risk of negative consequences arising, and ideally there will be metrics to assess this.²⁹ It is unclear, however, what these metrics are. Thus, attention is drawn to the uncertainty that makes deregulatory measures politically difficult: predicting the scale of consumer harm from any particular change or set of changes in regulation is difficult.

We conclude that liberating or encouraging retail consumers to invest in unlisted securities of growth companies will not quickly remove the equity funding gap facing the UK’s growth companies and, even if it were eventually effective, could impose unacceptable collateral costs.

Regulation in relation to wholesale investors

Wholesale investors are less protected (constrained) by regulation than retail investors. They already invest extensively in private assets such as unlisted equity of growth companies. Targeting protection of these investors is unlikely to transform capital supply to UK growth companies. Moreover, ‘PISCES’, the new Private Intermittent Securities and Capital Exchange System should encourage investors into unlisted, private, assets as it reduces the problem of illiquidity that typically affects them.³⁰

A related issue is the UK’s continuation of the EU’s Alternative Investment Fund (AIF) Managers Directive. This was introduced after the GFC to address the risks of AIFs to investors, market participants and markets.³¹ In its scope are funds with as little as £100m in assets, which is not obviously a market-threatening sum. The UK government now proposes a lighter regime for AIFs with funds up to £5bn.³² The consensus seems to be that this could boost investment in growth companies without creating significant risks, but this change is unlikely to make a material change to three quarters of funds under management ³³ while the ‘devil’ is in as-yet-unknown details.³⁴

Regulation affecting defined benefit pension (DB) schemes

Historically, UK DB schemes sought to meet their liabilities through substantial equity portfolios. This is no longer the case³⁵ due to the introduction of accounting standard FRS17, according to the Association of Corporate Treasurers.³⁶ Requiring sponsoring employers to record a liability on their balance sheets for projected shortfalls in their pension schemes is not wrong in principle, and it caused scheme closures and shifts to bond holdings. Cautious guidance from The Pensions Regulator is also said to have prompted the shift from equities.³⁷ We lack a strong opinion on this but note that, as often in regulation, there may be a difference between what authors intend and what audiences read. Academic research sponsored by the Institute and Faculty of Actuaries found that decision-making by pension fund trustees displayed significant behavioural biases. Relevant regulators should consider this carefully.³⁸ Cautious words can trigger strong risk aversion.

The former business model of UK DB schemes—lowering the cost of paying predictable liabilities through investing in volatile but over time higher-yielding assets—worked, and it continues to work around the world. Insurers accept pension liabilities for a lump sum and then seek to profit by more astutely investing the lump sum compared with the original scheme. We therefore believe that DB schemes, especially given the size of their asset holdings³⁹ and the macroeconomic significance of their holdings,⁴⁰ are worth further consideration as a source of equity for UK growth companies. The question is how this could be achieved without jeopardising pension payments in any material way.

The way forward

The UK has a complex and pervasive system of regulation. Risks and markets change over time—therefore some deregulation is almost certainly net beneficial. But our specific problem—routing billions of pounds of equity to growth companies to boost UK growth materially—requires large-scale deregulation, risking significant costs.⁴¹ We have seen that the costs of bank failure can be significant, and insurance companies can contribute to costly financial crises. The regulated culture of retail consumers against equity investment will take years to reverse, and deregulation could lead to more scandals. Wholesale investors are not hugely constrained by regulation, and relaxing the UK’s version of the Alternative Investment Fund Managers Directive will likely help but probably only to a limited extent. Again, listing rules may not be critical, while the costs and benefits of takeovers of growth companies by large players are moot. DB schemes cannot revert to equity-based portfolios under FRS17. In view of all this, we consider whether alternatives to substantial deregulation can engender a rapid, material increase in equity investment in growth companies without materially increasing systemic or consumer risks.

We focus on DB schemes because the business model of meeting fixed liabilities from a volatile asset portfolio, although not riskless, typically works, and because of the scale of pension assets that could quickly be deployed in this way through the flourishing Bulk Purchase Annuity (BPA) market.⁴² Can the BPA market itself direct sufficient funds to growth company equity, broadly under current regulations, without creating large incremental risk?

The BPA market works partly because the UK’s version of Solvency II allows capitalisation of a portion of the excess return on risk assets with predictable cash flows over the matched liabilities. Even after the PRA’s welcome reforms of the Matching Adjustment,⁴³ however, venture capital and scale-up equity are unlikely to qualify for it.⁴⁴ So the BPA market itself is unlikely to divert sufficient funds to growth company equity.

The question then is whether a scheme can be designed to deal with the issue of the Matching Adjustment, so that funds sufficient to impact growth materially can be moved from DB schemes’ cautious holdings to growth company equity. Given the size of the British economy, the funding shortfall faced by growth companies and the increment in growth likely to arise from transfers from bonds to growth company equity, a transfer of at least £10bn is likely to be required. For this purpose, a scheme which makes sense to us involves an independent vehicle that:

• receives assets from DB schemes and invests them in growth company equity;
• assumes DB schemes’ liabilities and passes them on to insurers;
• issues bonds to these insurers that (after ten or 15 years) pays the higher of the return on the growth company portfolio (less expenses) and the relevant gilt return;
• buys insurance from Lloyd’s of London and HM government (at the commercial rate) to cover any excess of the gilt return over the portfolio return, thus enabling the insurers to meet the pension liabilities and include the bonds in the Matching Adjustment—the probability of any such shortfall arising over a suitably long reference period is low, so the insurance should be affordable, while the commercial rate helps the government with any subsidy and balance sheet issues.⁴⁵

We are aware that at least one scheme along these lines has been proposed and, given the scale and urgency of the growth problem, we advocate that the government considers it and any sensible rivals quickly and with a ‘can do’ approach.