12.1 Borrowing and lending problems in nancial intermediation

12.1	Borrowing and lending problems in nancial intermediation

We saw in Chapter 2 that nancial intermediation should encourage both saving

and the borrowing of funds for investment and should channel funds to their best

use from the point of view of the overall economy. Over the years, however, there

have been many criticisms of the way in which the nancial system meets the

demands of its many clients. From the point of view of rms, the principal issue has

been the extent to which rms wishing to engage in productive activities are able

to obtain nance. In relation to households, there has been much discussion of the

extent to which people are able to take advantage of the benets of the nancial

system. In recent years, worries have been expressed as to whether the system pro-

vides sufcient incentives and information to encourage long-term saving. Indeed,

it has sometimes been argued that the nancial system is in part responsible for

the tendency of many households to go deeply into debt, while others do not save

enough. We discuss these issues briey here.

12.1.1The nancing needs of rms and attempted remedies

One major allegation has been that the nancial system has sometimes performed

less than satisfactorily with respect to those who wish to borrow from it. Until

recently, concern has largely centred on the relationship between the nancial system

and the nancing needs of rms. This has long been a matter of controversy.

The Macmillan Committee, for example, with J M Keynes as one of its members,

investigated the issue in 1931. More recently, the Wilson Committee (HMSO, 1980)

produced a voluminous report (and a dissenting minority report) on the function-

ing of nancial institutions which was for some years a major source of reference on

the structure and functioning of the UK nancial system.

Three themes run through this recurrent interest in whether the nancial system

is functioning satisfactorily. The rst, important in both the Macmillan and Wilson

investigations, is whether the system fails to cater adequately for the nancial needs

of a particular class of commercial borrower. The ‘Macmillan Gap’ was the name

given to what was seen as the failure of the system to provide funds cheaply and

conveniently for ‘small’ rms. The Macmillan Committee was not persuaded, but the

idea that something might be lacking from the spectrum of institutions providing

commercial nance has continued and lies behind various government-sponsored

initiatives, particularly in the 1960s and 1970s, to make it easier for small rms to raise

venture capital. The Wilson Committee recommended public support for a Small

Firm Investment Company and a loan guarantee scheme. In the 1980s, the idea that

small rms might be at a disadvantage had moved on a stage, with accusations that

they were treated less favourably in many ways by their banks, when compared with

the services provided to, and the prices faced by large rms.

More recently, venture capital trusts (VCTs) have been established in an attempt

to help provide nance for small expanding enterprises. They are companies quoted

333

..

FINM_C12.qxd 1/18/07 1:28 PM Page 334

Chapter 12 • Financial market failure and nancial crises

on the stock exchange which invest mainly in unquoted companies or newly-formed

companies. The government’s intention was that VCTs would nd the successful

companies and entrepreneurs of the future and allow them a start they might other-

wise have been denied. VCTs were introduced in the Finance Act 1995. They are

aimed at medium to large net worth investors who receive tax relief for investing

in what are seen as risky enterprises. Investors can put up to £200,000 per annum

(increased from £100,000 in 2004) in VCTs, which are required to have 70 per cent of

their money in qualifying companies within three years of their launch. Qualifying

companies are likely to be UK-based trading companies with gross assets of less than

£7m at the time of investment.

VCT shares issued after 5 April 2000 needed only to be held for three years for

investors to retain the initial tax reliefs. Beyond that, the benets become greater

the longer the shares are held. In fact, VCTs have proved to be much less risky than

was originally thought. All VCTs that have been running for a year or more have

paid tax-free dividends. After a fairly slow start, funds invested in VCTs rose to over

£400m in the tax year 2000–01 but then fell off sharply. In 2004, the Treasury

responded to this by increasing the income tax rebate on funds invested in VCTs

from 20 to 40 per cent. This produced a sharp increase in funds owing into VCTs

– to £500 million in 2004–05 and over £700 million in 2005–06. However, the

Treasury then decided that the scheme was too expensive in terms of the tax revenue

foregone and in the 2006 budget the income tax rebate was cut back to 30 per cent

and the minimum holding period required to retain these tax reliefs was increased

from three to ve years.

A second critical theme is that nancial institutions in the UK have been too ready

to provide nance to overseas governments and rms at the expense of domestic

industry. Certainly, overseas securities form a large part of the existing asset holdings

of UK institutions and the ow of funds into overseas securities grew strongly in the

1980s; as we noted in section 4.4, since the ending of exchange control in 1979 the

share of overseas assets in institutions’ portfolios has grown steadily. The export of

capital issue has, however, been a matter of debate since the late nineteenth century.

Undoubtedly because of its position as the rst industrialised country, the UK

nancial system has a long tradition of international nance and its institutions are

more outward looking in their search for protable opportunities than are institutions

in other, especially mainland European, countries. This has always been a matter of

some concern to the left in British politics. Since the principal function of a nancial

system is to mobilise savings or ‘wealth’ into productive uses it is clear that it is pro-

viding services primarily to those with property. However, in so far as the system is

effective in channelling surpluses into productive use in the domestic economy, the

propertyless gain some benet from the resulting output and employment. When

surplus funds are directed overseas, the only benets that accrue in the UK accrue to

wealth-holders alone. This criticism is often joined with allegations that UK economic

(and especially monetary) policy is too readily aimed at reassuring overseas investors

at the expense of production and employment in the UK.

A third but more recent theme is that the structure of the UK (and to some

degree the US) nancial systems pressurises rms into concentrating upon short-term

334

....

FINM_C12.qxd 1/18/07 1:28 PM Page 335