The UK needs a well-functioning financial sector which supports sustained and inclusive growth of the real economy.
he UK financial sector needs to encourage and mobilise savings, intermediate these savings at low cost into efficient investment that helps increase high productivity jobs, as well as helping manage risks.
Because the financial sector has such an important impact throughout the economy, it needs to avoid causing it harm. There should be as few and as small financial crises, as possible as these have huge costs, both fiscal and on growth, employment and investment.
In recent decades the UK private financial system has not performed these functions well. It created risk, instead of managing it, contributing to crises. It over-lent in boom times, and rationed credit during –and after-crises, limiting working capital and long term finance crucial for private investment. It has, in all times, not funded sufficiently the long-term investment which businesses need to grow and create jobs; key sectors like infrastructure have been insufficiently funded. SMEs have especially limited access to credit.
The limitations of the private financial sector have increasingly drawn attention in the UK, and internationally, to the positive role that effective public development banks can play to help fund private investment. The positive role these banks played in providing counter-cyclical finance as private domestic credit fell, since the global financial crisis started in 2007, is widely seen as valuable. Furthermore, there is a greater need for instruments, like a public investment bank, to implement structural transformation and increase competitiveness, with high productivity jobs, which allow good wages.
At a national level, in mainland Europe Germany’s public development bank, the very efficient KfW, now the second largest commercial German bank, has played a very positive role in increasing lending, for example to SMEs, during the crisis, as well as funding on a significant scale in all periods key sectors, such as investment in renewables and innovation more broadly.
There is much agreement that the KfW has contributed meaningfully to German economic competitiveness, growth and employment. It is striking that, as Nicholas Tott points out in his report for the Labour Party, the UK is the only G7 European country that does not have a public investment bank.
The fact that the Labour Party has announced it plans to create such a public development bank, the British Investment Bank,(BIB) is therefore to be greatly welcomed. In a time of relatively limited public resources, allocating funds to the capital of a development bank has the important advantage of significant leverage, as with £ 1 billion of paid-in capital, up to £9 billion loans can be generated; the funding for the loans will be raised on the private capital markets, in ways similar to the operation of KfW or the European Investment Bank. Furthermore, if private banks provide co-financing, total leverage can be even higher.
It seems important that the British Investment Bank has sufficient scale to achieve significant results. The scale of course will be mainly determined by the financing needs and gaps of the British economy
However, it may be useful to compare the BIB with the KfW, to give a rough idea of desirable scale .The KfW approves new loans per annum of around £46 bn for domestic purposes. As the population of the UK is around 80% of the German population, a comparable lending capacity for the UK would be around £ 36 billion p.a.
The total loan stock of the KfW is around £ 430 billion. If we assume a similar scale for the UK, in proportion to its population, (one possible criterion amongst others, for determining the scale of the BIB), the total stock of the BIB should reach £ 340 billion, after a number of years.
To get an understanding of the order of magnitude of the equity required in paid in-capital for a British Investment bank, to eventually lend on that scale, we assume a leverage of 1:9 to achieve the best rating, AAA. It is an interesting precedent that for the recent paid-in capital increase of the European Investment Bank, the ratings agencies suggested a leverage of paid-in capital to loans of 1:8 to assure continued AAA rating.
The BIB would need for a full revolving volume of loans of that magnitude, equity of around £ 40 bn. This would consist of paid-in capital mainly, but if the BIB has profits after it starts lending, part of its own funds would originate in those profits reinvested in the bank. This is what happens with institutions like KfW or EIB. An ideal way forward, to achieve high levels of loans soon and therefore increased effects on much needed investment in the UK economy (where both private and public investment is low, and fell sharply since the beginning of the crisis) is to put significant capital upfront, for example £10 billion a year, for four years, as the IPPR study argues.
A far more gradual approach is to start far slower, with for example a yearly injection of £1 billion of capital. Then, the volume of lending would be around £9 bn new loans for year one and for each of the following six years, stepping up to a volume of £18 bn as of year 8, if we assume average maturity of loans of the BIB of 7 years. In year 8, there could be additional loans of £9 billion due to increased capital in that year, and £ 9 billion loans, due to repayment of loans made in year 1. By year 14, the BIB could have a total level of lending of £190 billion, just over half of what the total lending portfolio of KfW is, if compared on a per capita basis. Though very positive, the build-up of lending would be somewhat slower than in the former scenario.
If politically and economically feasible, a more rapid and large initial injection of paid-in capital, closer to £40 billion injection over 4 years, may be desirable.
As regards sectors, clearly lending for infrastructure and SMEs are crucial priorities at present. Both are very important areas, where major funding deficits exist in the UK economy; both sectors are crucial for growth and employment. However what about the green economy and innovation? Whilst it seems excellent to start with infrastructure and SMEs financing, it seems desirable to leave the option open, to redefine priority areas in future.
The British Investment Bank is an initiative of potentially immense significance to the UK economy over the long term and it is excellent news that Labour has committed to its implementation.
Professor Stephany Griffith Jones is Financial Markets Program Director at the Initiative for Policy Dialogue at Columbia University