Is Financial Regulation Holding Back Growth? - NIESR

It has become something of a commonplace to argue that the UK’s regulatory framework for financial services is weighing on economic growth. This view was perhaps best exemplified by Chancellor Reeves in her 2024 Mansion House speech, when she described rules and red tape as a “boot on the neck” of business.

The charge sheet from the financial sector is long. The Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA) – the regulators charged with safety and soundness, and consumer protection respectively – are said to have an excessively risk-averse culture. The rulebook they have constructed is viewed as overly complex. There is alleged “mission creep”, with too much focus on issues outside the core regulatory mandate, such as net zero and diversity. Authorisations are processed too slowly, innovation is not being facilitated, and insufficient attention has been paid to the cumulative burden of regulation.

There is some truth in each of these claims. Regulators have strong incentives to be risk averse: they will be in the firing line if anything goes wrong. It is also hard to deny that the regulatory framework has become excessively complex. One is reminded of the quip attributed to Lord Palmerston that “only three people have ever really understood the Schleswig-Holstein business: the Prince Consort, who is dead; a German professor, who has gone mad; and I, who have forgotten all about it”. And it is undeniably the case that there has been no serious attempt to add up the cumulative costs of the post-crisis reforms.

That said, the central policy question is whether these complaints identify genuine impediments to economic growth – or whether they mostly reflect the financial industry talking its own book. In today’s blog, I try to shed some light on this difficult question. In a nutshell, my answer is that while there are undoubtedly elements of poor regulation that can and should be removed, we should not expect the growth effects of regulatory simplification to be large. And if we start to weaken the parts of the framework that really matter, history suggests the outcome is unlikely to be a happy one.

Let’s first make sure we’re asking the right question

It is important to be clear about what the right question actually is. The question is not “is financial regulation holding back UK economic growth?”, but rather: “is financial regulation reducing risk-adjusted economic growth?”. The distinction may seem obvious, but it is worth spelling out why it matters.

Consider a simple thought experiment. Imagine the economy five years from now, at the end of 2030. Suppose that if we maintain the regulatory standards built since the global financial crisis, the size of the economy is 100. Now suppose instead that regulation is relaxed. In that case, we are sailing closer to the wind: there is a 5 per cent probability of a financial crisis that would reduce the size of the economy to 90.

How much should we be willing to pay, in terms of a smaller economy today, to avoid that outcome? The answer depends on how risk-averse we are as a society. In the simplest case of risk-neutrality, we would be willing to devote up to 0.5 per cent of output – the expected loss associated with the crisis risk. If instead we are risk averse – more realistic case, given the very large economic and social costs of crises – we would be willing to pay more than that.

Even this stylized example makes the core point clear. The objective of policy is not to maximise measured economic growth in the short term, but to achieve the highest sustainable – that is, risk-adjusted – growth path over time. Yes, slashing some types of regulation could well boost growth temporarily. But if doing so materially raises the risk of a crisis, that growth would prove illusory, leaving the economy worse off than where it started.

In practice, the case for prioritising resilience is even stronger, since crises tend to impose permanent losses rather than temporary setbacks as the diagram below illustrates.

One piece of circumstantial evidence often cited in support of the “regulation is holding back growth” view is the UK’s persistently weak investment performance. The UK currently sits at the bottom of the G7 distribution in terms of gross fixed capital formation as a share of GDP. But as this chart from the Bank of England illustrates starkly, the UK has always devoted less of its national output to investment. That was true in the boom years of the late 1990s and early 2000s, when financial relaxation was lax by any reasonable standard, just as it is true today. Weak investment is a long-standing structural feature of the UK economy, rather than a problem that emerged in response to tighter post-crisis prudential and conduct regulation.

To go further, it helps to step back and consider what the academic literature actually says about the relationship between finance and growth.

Prior to the Global Financial Crisis, the prevailing view was deeper financial systems support faster economic growth. Influential work by King and Levine, Levine and co-authors, and Rajan and Zingales all pointed in the same direction.

Pre-2008 view: More finance is good for growth Post-2008 view: Beyond a certain point, more finance reduces growth

Chart from Levine et al (2000); see also King and Levine (1993), Rajan and Zingales (1998).

Source: Arnand et al (2012). See also Cecchetti and Kharroubi (2012)

The economic reasoning underpinning the pre-crisis literature is as follows. A well-functioning financial system can raise growth by mobilising savings and directing them towards productive investment, improving the allocation of capital across firms and sectors, and facilitating risk-taking and innovation by pooling and pricing risk.

In other words, the contribution of finance to growth is not primarily about the size of the financial sector itself or its gross value added. It is about its ability to improve economy-wide productivity by allocating capital and risk more efficiently.

Since 2008, that view has been qualified. While it would be too strong to describe a single settled consensus, a substantial body of post-crisis research suggests the relationship between finance and growth may be hump-shaped. At low levels of financial development, expanding finance supports growth. Beyond a certain point, further expansion is associated with weaker growth outcomes.

Why might this be the case? One argument is that the financial sector attracts an excessive share of highly skilled labour that could otherwise be deployed more productively elsewhere. Another is that political economy dynamics can lead to an over-sized financial system that reflects lobbying power as much as economic need. And of course, there is the argument that credit booms often end badly, with calamitous implications for economic growth.

A key question for the UK, then, is which part of this curve we currently sit on.

What are we asking regulators to do, and what have they been doing?

Since 2023, UK financial regulators have been operating under an expanded set of objectives. Alongside their primary mandates for financial stability, safety and soundness, and consumer protection, they have been given secondary objectives to facilitate international competitiveness and to support medium-to-long-term economic growth.

So, how have the regulators responded to this new remit, and are we likely to see a meaningful growth dividend from any of their actions?

The most significant recent example is the decision announced by the Financial Policy Committee in December 2025 to reduce system-wide capital requirements for UK banks from 14 per cent to 13 per cent. This move was explicitly framed as supporting lending and economic growth.

The difficulty is that there is little evidence that bank lending in the UK has been constrained by overly tight capital requirements. Aggregate bank credit is growing at around 5 per cent year-on-year, broadly in line with nominal GDP, and credit conditions surveys point to easing lending standards across mortgages, consumer credit and corporate loans. In short, there is little sign of a binding capital constraint at the system level.

That is not to say there are no financing frictions. Small and young firms do face material constraints, and these may matter for business dynamism and innovation. But these frictions have less to do with safety and soundness regulation and more to do with the inherent difficulty of lending to firms with little collateral, as well as the limited availability of patient, long-term risk capital.1 They are also unlikely to be central to the UK’s overall investment performance, which is dominated by large firms with access to internal finance and capital markets.

In this context, the most likely near-term effect of lower capital requirements is not a surge in productive lending, but higher distributions to shareholders. The best evidence we have is that there is little trade-off between capital regulation and lending growth – if anything, the relationship runs in the opposite direction.2 Higher pay-outs to bank shareholders may be privately attractive, but they are not obviously a growth strategy.

Regulators have also eased mortgage lending rules in recent years, with the explicit aim of supporting housing market activity and improving access to credit for first-time buyers. These changes include adjustments to affordability assessments and greater flexibility around loan-to-income constraints.

Again, the objectives are understandable. But it is far from clear that this channel delivers meaningful medium-term growth. Easier mortgage credit primarily reallocates lending towards real estate. The likely macroeconomic effects are higher house prices, higher household leverage, and increased turnover in the housing market. If we think about the determinants of the economy’s growth potential – fundamentally reflecting technical progress, physical and human capital accumulation, and labour supply – it is hard to see how these are materially affected by the mortgage market.3

Reporting and compliance burdens

A third area of regulatory response has been a concerted effort to reduce reporting and compliance burdens. This is, in many respects, a sensible agenda. Simplifying duplicative or low-value reporting reduces deadweight costs and frees up managerial and staff time. There are also legitimate questions about the optimal frequency and granularity of some regulatory exercises, such as stress testing, where the marginal informational gain may be limited.

But here, too, the growth channel is probably modest. Reducing compliance costs will improve bank profitability, but translating that into higher economy-wide growth requires additional steps. In principle, reducing compliance costs could free up resources for more productive use or lower entry barriers. In practice, these effects are likely to be modest: compliance staff are not easily redeployed, and entry into banking is constrained by far more than reporting requirements.

The PRA has also made technical but economically meaningful changes to the Solvency II framework, particularly to the “Matching Adjustment”, which allows insurers backing long-dated liabilities to recognise part of the illiquidity premium in their capital calculations. These reforms may be sensible in their own right, but there is little evidence so far that they have triggered a material increase in real-economy investment.

This is not a failure of regulatory intent. Prudential and conduct regulation is a blunt tool for addressing what are, at heart, structural problems in the real economy.

So where is the real finance-growth challenge?

If the binding constraint on UK growth is not, in the main, financial regulation, where does the real finance–growth challenge lie?

A useful starting point is the Financial Policy Committee’s own diagnosis. In its December Financial Stability Report, the FPC noted that:

“To meet the challenges of the future, the UK economy will require a flow of long-term capital to fund investments which improve the infrastructure that supports the economy, fund the development and deployment of new technologies that will drive productivity growth and support the transition to Net Zero.”

That framing is exactly right. The growth challenge facing the UK is not about marginal changes in credit conditions. It is about financing a large, sustained reallocation of capital towards new technologies, infrastructure and strategic priorities.

The orders of magnitude involved are material. Investment associated with AI and data centres alone is likely to require around £10bn per year over the next few years. Estimates of the additional investment needed to deliver the net zero transition cluster around £40–50bn per year for a prolonged period. Defence spending is also set to rise significantly, with annual outlays plausibly in the £50–60bn range. To this can be added persistent financing constraints facing some of the UK’s most productive and innovative firms, particularly those reliant on long-term, risky capital rather than bank debt.

The key question, then, is whether the UK financial system is geared up to fund long-duration, high-uncertainty investment of this type at scale?

Banks are unlikely to be the primary solution. Even where balance sheet capacity exists, banks are poorly suited to financing long-term, equity-like risk. Their comparative advantage lies in short- to medium-term, asset-backed lending, not in funding projects where returns are uncertain, back-loaded and heavily exposed to technological or policy risk. Loosening prudential regulation does little to alter this basic constraint.

Pension funds and life insurers, by contrast, should be central to the story. They have long-dated liabilities and are, in principle, natural holders of long-term risk. In practice, however, their asset allocation remains heavily skewed towards low-risk, liquid assets. This is clearly a priority for government policy, and recent commitments from the pensions industry to allocate a greater share of assets to the UK real economy are welcome. Whether these translate into a material shift in investment behaviour remains to be seen.

Venture capital also plays an important role, and the UK has genuine strengths here: it has the largest VC market in Europe and the third largest globally. But venture capital alone cannot shoulder the burden implied by AI, net zero and defence. Its scale is limited, and it is concentrated at particular stages of the firm lifecycle.

So what, then, are the real blockers? At heart, they relate to risk allocation and risk sharing. Much of the investment the UK needs involves uncertainty that private investors are reluctant to bear on their own, particularly where policy frameworks are evolving and returns may only materialise over decades. Addressing this challenge is less about deregulation and more about institutional design: how risks are shared between the private sector and the state, how long-term capital is mobilised, and how incentives are aligned across the financial system – including through public–private partnerships and forms of blended finance.

Seen through this lens, the limits of the “regulation is holding back growth” narrative become clear. Prudential and conduct regulation can and should be improved at the margin, and poorly designed rules should be scrapped. But regulation is not the binding constraint on the UK’s growth prospects. The harder challenge lies in reshaping the financial system so that it can allocate risk and capital in ways that support long-term structural change – something that cannot be achieved simply by taking the regulatory foot off the brake.

1 See “Unlocking growth: what can the literature tell us about what’s holding back high-growth firms?”.

2 See Gambacorta and Shin (2018).

3 Of course, there are channels. It could be that higher house prices mean more collateral available for small business owners, easing borrowing constraints. Ref that BoE paper. But this is unlikely to be a big effect.

An AI generated short summary of the main points of the above blog can be accessed below.