Author Archives: Mark Freeman

About Mark Freeman

Mark joined the School of Management in 2006, following previous full-time academic appointments at the Exeter Centre for Finance and Investment (University of Exeter) and the University of Warwick. He has held visiting academic positions at the Kellogg Graduate School of Management (Northwestern University), the University of California, Irvine, and the University of Technology, Sydney.

Before becoming an academic, he worked as an equity research analyst specialising in the brewing and distilling industries for stockbrokers Savory Milln and James Capel, in London. He also has corporate finance experience with United Distillers in Scotland.

Specialties: Economics of climate change, Long term funding of nuclear power, Pension funds - long term deficits

The flight to financial quality: what are the threats to UK businesses and the economy?

MoneyThe flight to financial quality: what are the threats to UK businesses and the economy?

Professor Mark Freeman is speaking at Beaumont Robinson’s annual client seminar on world debt and investing in the current climate on 11 October 2011. Mark is due to address the World Bank in New York on the following weekend.

According to the IMF Financial Stability Report, September 2011: “Financial stability risks have risen sharply in recent months, as slower economic growth, market turbulence in Europe, and the credit downgrade of the United States have weighed on the global financial system.”

Unsurprisingly, this has been associated with a significant downturn in business, consumer and investor confidence, which has led to a major flight to financial quality (movement by investors to purchase safer investments) over the last six months.


What is the impact on the sovereign debt position?

The market has become much more discerning when choosing which Government bonds it views as being “safe”. Crucially, the UK Government is seen as being a relatively safe haven, which has allowed it to borrow extensively at extremely low interest rates.

High debt and low interest rates means that the Government projects interest payments of £46.5bn in 2011-12 vs. for example £35.9bn on defence (HM Treasury Spending Review).

What are conditions like for the UK’s retail banks?

In light of the reasonably benign conditions for UK Treasury borrowing, banks are recovering from the credit crisis and are now facing the impact of a Euro-zone debt crisis. The continued high risks to banks means that they are also looking for quality both through holding Government debt and changing financial positions with the Bank of England.

What is the impact on UK businesses?

Changes in Special Liquidity Scheme repayments have meant that lenders have continued to repay more of the support funds than had been previously arranged in the voluntary repayment plan (European Mortgage Federation Quarterly Statistics, 2011 Q1).

As a consequence, conditions have remained very difficult for corporate borrowers.

However, despite this firms remain buoyant. ICAEW and Grant Thornton’s UK Business Confidence Monitor for quarter 3 of 2011 says that concerns about access to capital have reduced since the recession. Only 19% of firms said it is more difficult to access funds than it was a year ago compared to nearly 40% of firms in the third quarter of 2009.

What are the key threats facing businesses and the UK economy?

Taking all of this into account, there are a number of threats facing the UK economy

  • A major European sovereign debt crisis that leads to a banking problem in France – which in turn affects the UK through contagion
  • A worsening of UK Government debt management which leads to the UK no longer being viewed as a “safe haven”
  • A rise in UK interest rates – both for the Government budget and firm borrowing
  • A double-dip recession

My advice to investors at this time is to stay safe. Reduce your assets and don’t take on any risky investments until the European and worldwide economy is more stable.

Will your pension fund have enough in it to fund your old age? A regime switching approach to pension fund solvency

pensionIf you are a trustee of a pension fund, what keeps you awake at night?  One of the many concerns for pension fund managers, trustees and regulators is to make sure there will be enough money in the cupboard when it comes to paying out pensions in five or thirty years’ time.

1. Dramatic swings in pension funding

Over the last four years, the net funding position of defined benefit pension plans in the UK swung dramatically from a surplus of £149.2bn in June 2007 to a deficit of £208.6bn in March 2009 and back to a surplus of £48.4bn in February of this year.

These fluctuations were primarily caused by two factors; changes in asset values following the credit crisis, and sharp declines in interest rates, which caused the present value of future liabilities to rise steeply.

2. Statistical models for pension fund deficits

Working with colleagues from both the University of Leeds and University of Strathclyde, we are working on statistical models that predict the probability of a pension fund being in deficit far more accurately over long periods of time.

A key warning for pension fund managers and trustees is that under current models, money invested today is predicted as seeing a 3 ¼-fold return over a 30-year period – with a probability of 97.5%.  Under our new statistical models, it may be under a 2¾-fold return.

3. What could a dollar be worth in 30 years?

In figure 1, we simulate the dollar future value of $1 invested in a pension fund whose assets have been split 20% US equity, 30% UK equity, 10% Europe equity, 10% Japan equity and 30% UK Treasuries.   The red lines show the projected returns using the traditional ‘one-state’ model; the blue lines take account of the more complex world we live in and are based on the new four-state model.


The largest differences appear at the top end of the model – the traditional model shows a 2.5% chance of growth to $61.08, whereas, for our more advanced model, growth is up to $78.51 with this level of probability.

While this may appear interesting to some, the focus for pension fund trustees has to be watching the worst case scenarios.  In the four-state model, there is a 2.5% chance that the future value of the dollar invested will be below $2.73 in thirty years, against the traditional one-state model which would have predicted this at $3.34.

In these cases, the more sophisticated statistical model implies a greater risk of future pension fund solvency problems.

4. Pension funds must remain solvent

The concern for every pension fund manager and trustee has to be ensuring that their fund will remain solvent into the future.  This new way of modeling better accounts for the real world of financial market peaks and troughs and will ensure that investment decisions are based on more accurate probability assessments of future pension fund surpluses and deficits.

Balancing sustainability with low cost energy - what are the priorities for UK business?

balancing sustainability2What should the government’s energy policy focus on?  This was the question posed to a small group of regional business leaders by Dr Neil Bentley, the CBI’s director of the business environment.  The dinner, generously hosted by Irwin Mitchell, is part of the CBI’s process for listening to businesses across the country to inform its own views and lobbying.

 1.      Is the energy market working?  

The main topic of debate was whether the market in energy and government policies and subsidies  are achieving the goals of secure and low carbon energy at competitive prices .  Concern was expressed about the extent to which government policy was leading UK energy suppliers to pursue projects that may turn out to be against the broader economic interests of the country.  If the UK takes a stronger environmental position than our overseas competitors, funded by public subsidy or higher future fuel bills, then the ability of industry to compete internationally could be eroded.   

 2.      Localism could exacerbate energy problems

There was also concern expressed over the government’s strong drive towards localism.  Given the political pressures on local governments and the potential lack of an over-arching national framework, the consensus around the table was that this was likely to exacerbate energy policy problems.  Overall, strong support was expressed for a balanced national energy strategy, driven more directly – but not exclusively – by a market based approach.  

 3.      Sustainability and climate change are not the same

What I noticed in the discussion was the tendency to somewhat conflate the terms “sustainability” and “CO2 reduction”.  My own reading of the political and societal position, though, is that while “sustainability” is gaining ever more public credence, “climate change” as a driver for policy is starting to decline.  As evidence for this, I would note that President Obama did not refer directly to the term “climate change” once, in his most recent State of the Union address while today’s Daily Mail shows that public scepticism is on the rise.

There are, potentially, three reasons for this.  First, it may reflect the fact that, with more pressing economic concerns, this is temporarily on the back burner (no pun intended).  Second, following two very snowy winters in the Northern Hemisphere, there may be some confusion between “weather” and “climate” in the public’s mind.  These are both, potentially, short-term issues that will have little impact on longer-term energy policy.  What I think is of more concern is that, since Climategate, the uncertainty over the science of climate change is becoming much more broadly recognised, including by the government’s own chief scientific advisor.

 4.      What will the public pay to prevent catastrophic climate change?

This raises the question as to how much the public will be willing to pay to stop potential catastrophic climate change even when there is great uncertainty.  It seems to me at least possible that the political consensus will change over this within the next decade, particularly if we have more cold winters and more uncertainty about energy security.  “Sustainability” as a policy driver is set firm, but “CO2 reduction” as the primary way of achieving that looks, to me at least, more uncertain politically.

Should this turn out to be the case, then this will have important consequences for a number of current initiatives, most notably, perhaps, carbon capture.  

5.      Where should energy investment be focused?

A further question that arose was the extent to which energy policy should balance investment in proven energy sources with significant economic or environmental costs, against a more speculative investment policy in new energy technologies.  The energy nirvana is for low cost, highly sustainable and secure energy supplies and, occasionally, there is some scope for optimism here. 

For example, this week, two scientists in Italy claim to have a commercial ready cold fusion reactor.  While there is, rightly, much scepticism expressed over the ability of this fuel source to be a realistic answer to our energy problems, the US Navy has been actively researching into cold fusion for many years. 

Is the UK Government doing enough to encourage speculative research in this area – and where should their focus be?

Will UK corporate lending improve in 2011?

money-1900One of the many interesting new things that I have done in 2010 is to talk to local business associations over the year about the outlook for business credit following the credit crunch.  This started with the Ilkley Business Forum back in January and now, nearly 12 months on and with the Bank of England’s Financial Stability Report being published today, I thought it would be a good time to review how things have gone, and what the outlook is now.

1. Credit conditions remained difficult in 2010

My argument over the year has been that credit conditions were likely to remain difficult.  There were several reasons for this.  First, the government needed to raise substantial money from financial markets, which would result in a “crowding out” of the corporate sector.  Second, the banks would soon be expected to return money under the special credit arrangements that arose during the credit crisis; for example, the Special Liquidity Scheme (SLS).  Third, UK banks have considerable risks on their balance sheet; not least the exposure to the PIIGS of Portugal, Ireland, Italy, Greece and Spain.

2010 has seen corporate credit conditions remain very tight.  In the 12 months to August 2010 – the latest available figure – overall lending to business was down 5.4%.  Mortgage lending has also been largely flat.   There is some evidence of credit conditions starting to improve for larger companies and in wholesale markets, but the SME lending market remains very difficult.

2. Conditions as they stand at the end of 2010

Many of the underlying problems remain.  UK banks are heavily exposed to debt default in the periphery of the Eurozone.  Credit default swap (CDS) rates are a core indicator of the risk here. These can be seen as insurance contracts – the higher the rate, the bigger the risk.

When I spoke to the Yorkshire Independent Financial Adviser Forum in May, CDS rates were 3.26% for Portugal and 7.33% for Greece.  Despite all the Euro bailouts, today these numbers are 4.57% and 9.68% respectively.  This problem makes the news, yet again, today through the Financial Stability Report.   The repayment of finance under the SLS has also kept journalists busy this week.

3. The good news for 2011

The good news is that the UK government is starting to attract foreign investors back into the Gilts market, putting less pressure on domestic investors to fund the government.  If foreign banks and investors can be encouraged once again to provide liquidity to the UK in all sectors, then things will improve.

My forecast for 2011 largely hinges on the Eurozone.  If things quieten down there, then I am more bullish than I was at the start of 2010 – we might expect a slow but steady recovery.  If, though, there is a Euro earthquake, which cannot be ruled out, then the aftershocks will be felt strongly by borrowers in the UK.

What are your views – Euro earthquake or a steady recovery?

Securing medium-term funding – businesses should act now

Financial graphVince Cable says the banks must get lending, as ‘they have been accumulating reserve capital beyond their requirements’.

Businesses should be wary. Don’t think this means funding is finally about to be released. In fact, my recommendation would be to make sure you do everything possible to secure medium-term funding requirements now.

While credit conditions have eased somewhat in recent months, businesses are still repaying more to banks than they are receiving in new credit.

Net funding of UK businesses (£bn)


Net funding of UK businesses (£bn)

Net funding of UK businesses (£bn)


Quarterly totals. Source:

This figure clearly reveals a decline in funding in the first quarter of 2010 despite the fact that the economy has been displaying clear signs of improved stability over the last year. The most recent data confirms this short-term downward trend. In April 2010, mortgage lending was 12 per cent less than in March and the worst figure for the month for a decade, according to the Council of Mortgage Lenders. In March this year, the Bank of England found that corporate lending was nine per cent less than in February, with borrowing at the lowest levels for more than a decade.

As the graph above shows, at the peak of the boom in 2007, banks were net lending about £40bn a quarter to UK businesses. The point of concern is that the banks face three other major exposures of this order of magnitude at the moment.

1 £200bn bank bail-out

UK banks were bailed out to a tune of £200bn, in total, by our government at the end of 2008/early 2009 through initiatives such as the Special Liquidity and Credit Guarantee Schemes. The timetable is for these schemes to start to be unwound from the middle of next year and the Governor of the Bank of England has made it clear that this will not be extended. As Michael Coogan, director general of the Council for Mortgage Lenders has been recently quoted as saying, “Unless funding issues are addressed, any recovery in lending may well be curtailed as the repayment date on the support schemes gets closer.”

2 £150+bn Southern European lending

At present, there is the distinct possibility that the governments of Greece, and some other Southern European countries, may default on their sovereign debt. For example, at today’s rates, an investor would need to pay over 7 per cent of the nominal value to insure Greek sovereign debt against default over the next five years.  Much of this debt is held by banks in Europe with UK institutions alone having lent about £150bn to the PIGS nations (the acronym given to what are seen as the weak economies in Europe – Portugal, Italy, Greece and Spain). Should default occur, this would put additional pressure on the banking system and risk a double-dip banking crisis in Europe.

3 Crowding out

The UK government is going to need to borrow over £100bn a year from financial markets for the foreseeable future to fund its budget deficit. This is an historically unprecedented number. In 2009, finding investors for this debt was considerably eased by the Quantitative Easing (QE) programme, where the Bank of England bought existing UK Government debt back from financial institutions and thus boosted their liquidity. However, QE has now finished – at least for the time being – meaning that the Government is taking considerable amounts of net money from the markets.

While it would be great if Chinese, Kuwaiti or other foreign investors would come into the market to take up this debt, the evidence suggests they are not doing so. Therefore, it will fall on British institutions, including the banks, to provide this funding. The Government may facilitate this through the regulatory process, insisting that financial institutions need to strengthen their balance sheets by adding more secure assets – such as gilts.

If British banks and other investors are being pressured to fund the Government, then there will be less availability of capital to put into the corporate or mortgage sectors.

Given these three stresses on bank liquidity in the UK, it looks as if it may be a long haul before there is anything like the availability of capital in the UK economy to get businesses growing again.

Uncertainty hung parliament – impact on UK financial markets

expectationTwo huge stories engulfed UK financial markets overnight. The first was that early yesterday evening, British time, the Dow Jones index fell nearly 10%, before rallying to end “only” 350 points down on the day. Then in the early hours of today, despite scepticism over the exit polls’ prediction of a hung parliament, it became clear that the Tories had failed to secure an overall majority.

As might be expected, UK financial markets have responded badly to this uncertainty. Sterling is significantly weaker against the both the dollar and the euro, the stock market has fallen and bond yields have risen.

So what is the main driver of all of this?

The fall in the US market can be mainly attributed to continued problems in Greece. But, when this situation was escalating last week, there was very little reaction in British markets. The all-important Credit Default Swap prices – which indicate how risky investors think British Government debt is – stayed steady, as did the £/$ exchange rate and bond yields. The implication is that the markets currently consider Britain to be currently fairly well insulated from the growing problems in southern Europe.

So, is today’s market slide primarily a response to the election results, rather than, as some may believe, the unfolding crisis in Greece? There is certainly evidence for this. Bond yields have risen since markets opened at 1am and the main fall in sterling happened around 6am – both long after the US market had closed. Also, if this is primarily a Greek-driven problem, why has sterling been so weak against the Euro this morning?

In light of the evidence, my view remains that it’s what is happening domestically, rather than what is happening internationally, that is primarily driving UK financial markets today.

Let’s hope the politicians get the uncertainty resolved quickly.

Carbon capture technology – who will pay the cost?

powerThe Today programme this morning had a feature on a capture carbon initiative at a coal fuelled power station in Scotland.  The feature covered the technology and environmental issues extensively, but didn’t address the economic questions that are integral to this issue.  This got me thinking – how much is this going to cost us?

According to Haq et al. , each of us in the UK has a carbon footprint of just under 12 tonnes per year, of which 3 tonnes comes from the “home and energy”.   As the average household has 2.36 people according to the Office of National Statistics , this is around 7 tonnes of CO2 emissions from each home each year.  Gough and Shackley estimate the costs of carbon dioxide storage in the UK at between £25 and £60 per tonne of CO2.

A bit of simple maths then reveals that the cost of capturing all the carbon from the average home is likely to increase fuel bills by between £175 and £420 per year.   This compares with the current average of around £1,300 per household per year.

Are you willing to pay this much?  Will you still be willing to pay it if and when oil prices go back to over $140/barrel?   Would you be willing to pay four times this amount to capture all your household’s carbon, rather than just that which comes from heating the home?  I think this would make an interesting follow-up feature on Today.