John Thurso, shareholder engagement and the regulatory turn

I've blogged previously with a bit on John Thurso's comments on the effectiveness, or otherwise, of shareholder engagement. It seems like it's something he is warming to. Today I was sent the following section from the banking inquiry's evidence session in late November. But I'm actually posting up a whole chunk as the discussion goes into the question of the role of shareholders compared to that of regulators. All emphasis below is mine.

Q13 Chair [Thurso]: I am sorry, I am going to throw this across. You and I are having a fascinating, almost private, conversation. It strikes me that there is a real problem with the Walker and Kay approach, of saying, “What we need to do is get the shareholders involved lots more”, for the very reason that you identified—the vast majority of large shareholders have less than 1%. This is not like an AIM company where five shareholders will own 75% and can act like owners. This is just a commodity called their stocks and shares.
Therefore, to say, “Let’s get them all involved”, really just adds complexity almost rather than providing any form of solution. I put this to you as a proposition: what one really has to try to do is look to the non-executives to act as if they were the owners and to take that stewardship on board as a primary task, much more than in companies where those owners are able to do that for themselves.
Professor Franks: I am afraid to say that, if that model would work, we would not need owners and we would not need capital markets. I do not think directors can substitute for ownership. If they could, capital markets would have very little role. Forgive me, but I think we have to look for structural solutions. That does not mean that we should not try to improve the governance of banks. There are lots of things that we can do but we have to have the structural changes as our main defence against systemic risk.
Q14 Chair: I am going to open that conversation up to the other three.
Dr Hahn: If we look at what happened in the crisis, there was a consensus between regulators, Governments and shareholders, that for large financial institutions shareholders did not know what was going on and couldn’t exercise governance. Why? Fragmented shareholders and those in a mostly passive investment world—index funds only are the major shareholders in banks. Many of the tasks that are bread and butter to a typical board of directors—choosing new chief executives, approving mergers, dividends, even bonus pools—are now subject to regulation. It is not just in the UK; it is EU-wide and the USA.
There has been a broad acceptance of the fact that shareholders are incapable of understanding what goes on in a complex financial institution. The question always goes to the board, trying to understand what the board should know, could know and what our expectations are of the board. Ultimately, there is a much bigger question, and that is the Andy Haldane question you raised about simpler regulation. Certainly some avenues: yes or no. Realistically, the only institution that can understand the risk that is being undertaken by a bank is its regulator. The regulator gets substantial inside information; it knows a lot more than the market place. The only one that can judge whether a board is monitoring the risks inside an institution is the regulator. We need to figure out in structure how a modern board works with regulation and with shareholder interest.

This is, of course, a bit of a theme of mine. For all the noise around stewardship, my own view is that the lasting outcome of the past few years is that the role of shareholders in the governance of financial institutions has been eclipsed by regulators. Pay, board appointments and even M&A are now seen as legitimate issues for regulators to discuss with banks, and the regulator is willing to step in where necessary. Shareholders get to have a look once the regulator has already kicked the tyres, as it were.

Thurso's comments are interesting as he seems to see shareholders as basically being speculators (hence his scepticism about engagement). But actually we might be about to hit a point where shareholders are, for once, actual investors, as we may well see rights issues this year. As I pointed out previously, the recent ABI report essentially sets out what their members expect if investing in banks, so it looks like they expect to be tapped up soon.

That aside, though, what's interesting about the above exchange is the sense of agreement that shareholders can't really do the job.