As next year’s general election approaches, politicians on both sides are likely to curse the financial sector for absorbing precious funds that could otherwise have gone towards healthcare, education and other social services. The complaint is not strictly fair, since the headline rescue packages – £250bn of loan guarantees, £50bn of capital injections and £200bn of special liquidity assistance – greatly exceed the amounts of public money the misadventurous banks will actually absorb in the longer term. Most will return to the Treasury once the banks revive, and private owners can shoulder their risks again.

Even so, the consequent short-term rise in public borrowing – to a projected (and likely exceeded) £175bn in the UK this financial year, from £30bn in 2008/9 – puts a strict cap on what can be afforded for the NHS, schools, universities, and the rising numbers in the real economy who lost their jobs when banks lost their capacity to lend.

For years, Britain’s financial firms – especially those clustered in the City of London – justified their stratospheric pay and comparable political influence through their disproportionate contribution to the economy. According to Reforming Financial Markets, the Treasury’s response to recent troubles published in July, financial services generate 8% of our national output, employ more than a million people, and finance our otherwise unsustainable appetite for imported food and manufactures, contributing £38bn to the balance of payments even in the crisis year of 2008.

Bank of England, London.

The financial sector – with important centres in Leeds, Edinburgh and the south-west as well as London – is also credited with paying over £250bn in tax and National Insurance since 2000. The tax on financial incomes was, as The Love of Money Programme 2 showed, a significant contributor to the revenue boom that allowed the new Labour government to spend more on hospitals and schools after 1997.

But now that it’s absorbing rather than enlarging the nation’s wealth, people are bound to ask if finance can still justify its unusual size and influence. Even the chairman of the Financial Services Authority, Lord Turner, has been forced to raise the issue. Turner stunned the City on the 27th August by wondering out loud if our bankers, brokers, insurers and investment managers have moved from dynamism into sclerosis. He actually dared suggest that the industry the FSA regulates has grown too large – and that it promotes too many financial transactions, making the case for a Tobin Tax to slow the flows and stop investors chopping and churning so frequently.

Is Turner right? The argument that Britain’s finance has grown too big for its bonuses goes much wider than its recent implosion and the budgetary black hole. Even in the good times, critics argued that the City starved UK industry of capital through its century-old preference for investing abroad – and starved it of skilled labour by sidetracking top minds from real into financial engineering. Policies designed to make the UK attractive to foreign money were accused of holding back domestic enterprise – by keeping interest rates and the exchange rates too high, demanding short-term profit, and regulating so lightly that excessive risk-taking and fraud were bound to arise.

The big City ‘s usual defence is that its growth reflects success, caused by Britain having a comparative advantage in financial services. We therefore don’t just produce them for ourselves, but sell them to the rest of the world – capturing a useful chunk of other nations’ savings, which we can usefully invest in our own industries, infrastructures and public services. But there’s a darker side to this expansion, which Turner was already raising in speeches earlier this year. Being a financial hub makes the UK unusually exposed to risk, and contagious loss of confidence, when the wheels fall off the banking wagon. And some (if not most) of the sector’s recent profit may have come from adding to financial costs – by extracting a ‘rent’ from the real economy – rather than reducing those costs, and assisting industry, as an efficient financial sector is meant to do.

Finance is 8% of Britain’s GDP and is still a lot smaller than manufacturing’s 14%. The finance share has dropped from a peak of almost 11% in 1986, not least because that year’s Big Bang substantially cheapened many of the services it sells to other sectors. That deregulation was followed by an investment boom which helped some of those sectors (especially IT and other non-financial business services) grow substantially larger.

UK stock market data on a computer.

True, our major banks (and, in America, the biggest insurance company as well) have been given substantially larger assistance than the car, steel, coal or textile industries could have dreamed of during their consequently more protracted and painful structural upheavals. And whereas these industries had to shrink to survive, finance has been supported so it doesn’t have to downsize. That’s because bank collapses can send much bigger shock waves through the economy than any factory or mine closures.

On the other hand, UK agriculture – contributing less than 1% of GDP and half a million jobs – receives an ongoing subsidy of over £3bn per year. Farmers say a continued flow of home-grown food, and a working countryside, are essential. Bankers maintain (with economists’ support) a continued flow of credit is equally vital; and that we wouldn’t get on affordable terms without the investment instruments and risk transfers that financial markets provide.

Of course, most household saving and small business investment is done through commercial ‘High Street’ banks, which for most of history were separated from the City-based investment banks, and could be so again. But Turner’s FSA has, instead, sanctioned a deeper integration between commercial and investment banking, passing over the chance to re-impose a separation. The investment side, leeching capital a year ago, is now propping up continued losses on the commercial side. So it looks as if your High Street (or internet) bank will remain securely fastened to a very large, and still poorly understood, financial reprocessing unit in the backstreets of east London - whether the regulators believe it’s an essential extra limb or just a peacock’s tail.

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Alan Shipman is lecturer in economics at the Open University, and a former financial journalist. His books include The Globalization Myth, The Market Revolution, and Transcending Transaction. He is involved in OU's new courses on personal finance, and research on insurance pools, 'chaos pricing' and Eastern Europe.

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The programme Supersave Me went through a list of different investment and speculative alternatives, from short-term savings products through shares and property to betting on the horses. It looked at different attitudes to investing at different stages in the ‘life course’, with younger savers more interested in setting money aside for a rainy day or a deposit on a house and older savers keen on having an income in retirement. It showed how most savers want to choose themselves, believing they have an edge in choosing cars, property, share or racehorses. And they were all aware that there is risk involved.

There are a number of simple ways in which you can get the risk return trade-off that suits you. Some people, say close to retirement, don’t want too much risk; others, younger, are looking for capital growth which only comes with risk attached. If you have a nest egg, or are saving monthly, just decide how much you can afford to lose. For example, with a £10,000 nest egg, would you be able to survive if it fell to £5,000? Or can you afford only to have it fall to £8,000, say? The smaller the fall you can afford, the less risk you can take on.

Lady holding a piggy bank
with dollar bills falling from the sky.
[image © copyright Photos.com

The stock market, for example, can, as we have seen, fall 40 to 50% in a single year, although that is a rare occurrence. So, decide up front, how much you can afford to lose. It’s likely that if you are in your fifities, you will have a higher minimum value on your nest egg than a thirty-something with years to go before retirement.

You also have to decide your time horizon. If you are investing for 10 or 20 years, and can afford to hang on to your investments, you shouldn’t worry about short term falls as, at some point in the future, prices will recover. That is true of property too, but the problem with property is that it tends to be a ‘leveraged’ investment. People tend to borrow to invest in property, so that a fall in the value of the property or in rents can mean that the loan is called in and substantial losses incurred. People tend not to borrow to buy shares so investing in shares is less risky than borrowing to invest in buy to let.

But the simplest way to make sure you maximise your expected return for a particular level of risk is to diversify across different kinds of assets. Put simply, don’t put all your eggs in one basket. Put some in cash, some in bonds, some in shares and possibly some in property or another ‘alternative asset class’ such as gold or even classic cars. By so doing, you will be making sure that at least part of your savings doesn’t fall. For example, when the stock markets were crashing in 2008, investments in government bonds were racking up capital gains of 30% or more. And if your pot is not big enough, there are plenty of investment trusts or unit trusts who will diversify on your behalf.

And, finally, if you are investing in the stock market, don’t invest it all at once. Regular saving, so called ‘dollar averaging’ means that you don’t put all your money in at the top of the stock market cycle and also that you do put some money in when shares are cheap. Regular saving avoids the classic small investor’s temptation – to buy at the high in the heat of a stock market boom and to sell when prices have gone down.

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Janette Rutterford is Professor of Financial Management at the OU Business School, having previously worked in corporate finance and investment. Jannette's research includes pension funds, equity valuation and investment history, in particular the history of women and wealth.

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How much attention should companies pay to their share price?

Share prices of all companies have certainly been volatile in the past couple of years. Indeed, individual shares have risen or fallen as much as 25% in a single day. As well as that, most shares have fallen in value by around a half in the past two years and are back at levels seen five or more years ago.

Executive directors had bonuses in share options, so boosting share price made them personally richer

In the twenty first century, shareholder value became the new corporate mantra. CEOs and directors of companies had as main objective the maximisation of shareholder value and that meant boosting the share price. A couple of simple techniques were developed to do this: share buybacks and takeovers. Borrowing money to carry out share buybacks meant more leverage on the balance sheet which meant greater percentage profits growth in the boom years.

Buying companies using debt also increased leverage and allowed the stripping out of surplus cash as dividends. Since executive directors all had bonuses in the form of share options, the more they could boost the share price, they richer they personally became. Directors certainly paid a lot of attention to the share price as the inexorable rise in the early twenty first century could be used to keep investors happy and provide a measure of bonuses to come.

In the bear market since 2007, share prices have fallen faster than ever before - partly due to the embedded leverage of many companies. The worst to suffer have been property companies, financial services companies, and private equity firms whose investments in companies were themselves highly geared. Indeed, for many firms, the options included in bonus packages are 'under water' and new ones at lower prices have been issued.

But falling share prices have other consequences for management. One problem now for many companies is whether they are going to be forced into liquidation as they breach debt covenants. The share price is a reflection of investors' perception of that probability. The lower it is, the less likely that investors will be willing to refinance the firm. Recently, some rights issues have had to be done at 50% or more discount to the current, low, share price to be successful. And, by law, firms cannot issue shares for less than their nominal values of say £1 per share or 25p per share.

Another problem is the lack of loyalty of today's shareholders. In the old days, retail shareholders and institutional investors could be relied upon to invest for the relatively long term. No more. Today’s investors include hedge funds which are just as willing to sell as to buy shares. Some of the major UK banks have ended up part nationalised after sudden collapses in their share price after short selling by hedge funds. Although some people argued that short selling was not the cause, it was banned for a time in the UK on certain shares and even now has to be disclosed.

A low share price makes firms vulnerable, either to bankruptcy or to takeover. And the last thing a CEO wants is to lose control. Just look what happened to John Thain of Merrill Lynch after the takeover in extremis by Bank of America!

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About the author

Janette Rutterford is Professor of Financial Management at the OU Business School, having previously worked in corporate finance and investment. Jannette's research includes pension funds, equity valuation and investment history, in particular the history of women and wealth.

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