Regulatory turn - more evidence

Mark Kleinman seems to get quite a few stories like this. The big point to me is that this kind of thing is now going on all the time. It's an interesting to note that the Stewardship Code was developed specifically in response to the failure of shareholders to engage effectively with the banks, yet it's precisely in the banking sector where shareholder primacy is being squeezed out by more active regulatory intervention.

The City regulator is leaning on Britain's newest high street bank to strengthen its boardroom line-up following a tussle over the appointment of its billionaire co-founder as its next chairman.

I understand that Metro Bank plans to reshuffle its line-up of directors to assuage concerns expressed by Financial Services Authority (FSA) officials about the elevation of Vernon Hill to become its chairman, which was announced on new year's day.
Insiders say that Ben Gunn, an existing non-executive director of Metro Bank and a City veteran who has run Friends Provident, the life and pensions group, is likely to become the lender's new vice-chairman.
Lord Flight, the senior independent director at the fledgling bank, will relinquish that title but remain on the board as a non-executive director, according to people familiar with the plans being discussed by directors. The proposals are still subject to change, insiders said.
FSA staff are understood to have told Metro Bank that they wanted a more established banking and financial services figure, such as Mr Gunn, to occupy a more senior role on the board.

The end of the 1990s

Something is definitely going on in corporate governance in the UK. On the surface it looks like our model remains the same. If anything one might conclude from the noise around the Stewardship Code that a shareholder-focused governance model was becoming ever more entrenched. The ideas floated by the Coalition about executive pay reform also seem to take for granted that really this is a matter for boards and shareholders.

And yet the evidence that some sort of shift is underway is all around us. As I have mentioned previously, the role of the FSA is worth a look. For example, last week Sky's Mark Kleinman got another nice story, this time about the FSA telling the heads of the UK-listed banks that they should try and clawback bonuses from an executives involved in the PPI mis-selling debacle. If any mainstream asset manager has had a conversation like that with the banks I would be very surprised. Of course the FSA has an interest due to the Remuneration Code, but if all companies are supposed to introduce clawback in the future this is exactly the sort of thing that asset managers will need to do if the thing is going work.

It's just the latest in a string of developments that demonstrate very clearly that the FSA is willing to intervene in financial services companies. And remember that it wants more power (to block hostile takeovers, for example). I've called this a regulatory turn, maybe I'm wrong, but there is something going on.

Of course, we have also seen that the Government is willing to get stuck in over bonus policy at the banks (and perhaps others). Thus far it's clearly been a kneejerk reaction to opposition pressure, and no doubt this is because the Tories in particular don't want to end up on the wrong side of public opinion. The impact in turn on the banks could be, incredibly, that the state-owned, or part-owned, banks will move away from bonuses. The greater emphasis could be on LTIPs, which wouldn't be a 'win' in my opinion. But still, political pressure is there in a way it hasn't been before.

As I've blogged recently this has also led Labour to push its thinking on a bit. This was always inevitable a) given that our existing position didn't go much beyond existing best practice and b) once the Coalition demonstrated its willingness to go further, within the existing model. So I'm very interested to see a number of Labour figures make some simple but important points about bonuses - they have become an expectation rather than a reward for exceptional performance, the evidence that they work to motivate is limited etc.

Meanwhile there seems to be a sense of incomprehension within the investor governance community. A combination of regulatory an political intervention is starting to make the views of institutional investors about pay at the banks a bit irrelevant. At the same time they seem unable to shift away from what they've always done. The reaction to the ideas floated by Vince Cable is a case in point - I think BIS probably got the message from most investors (and their representative bodies) that nothing much needed to change. So they have been left looking well off the pace with the Government coming out in favour of binding votes etc. Similarly I've been banging on about the flaws in performance-related pay for two or three years now, and it does seem that scepticism is growing. It wouldn't surprise me if this took off in the public policy world, yet investor bodies don't event seem aware that the idea of tying cash/shares to performance might be a bad idea in essence, rather than because of flawed implementation.

The thing is, if the investor community is in a bit of a mess over remuneration, what are they actually good at challenging companies over? I think the average vote against a remuneration report was about 6% last year, whilst the average vote against a director was around 2% and against an auditor appointment about 1%. It gets worse when you consider that voting at UK companies is becoming distorted by overseas investors with their own priorities. Last year the average vote against a company seeking authority to hold meetings on short notice was waaay higher than the average vote against a director. Already this season we see that overseas impact - look at the Compass AGM last week. Or Imperial Tobacco. In what world is holding meetings on short notice the most important issue?

That in turn will add to the pressure from corporates to regulate the proxy advisory sector. I'm not inherently opposed to this, but I do think the pressure for it is coming from the powerful business lobby in the US. Inexplicably some in the UK are now parroting lines from the US. Whatever you might think about proxy advisers a) it's up to the investor ultimately to decide how to vote and b) more pressure on the sector is only going result in less challenge to companies. It's hardly the case that the UK is littered with cases of directors being voted off boards because of the advice of proxy voting advisers - so what problem are we seeking to address.

At the same time people are getting nervous about what cases like Aviva and Henderson (and Insight) mean. Aren't we supposed to be in an era when shareholders take their wider responsibilities seriously? Well obviously, even after all the noise about mainstreaming responsible investment, it turns out that asset managers think that it's a relatively painless cut to get rid of ESG specialists. According to Aviva they don't get the money in to justify the expense. .

Add all this together and I think something significant is going on. What I actually think we are seeing is the end of the 1990s model of corporate governance. The policy prescriptions that went with it - transparency and disclosure, beefed up shareholder powers, executive pay aligned with shareholder interests, principles-based approach - no longer seem up to the task. The changing nature of the shareholder base of UK companies only adds to the confusion.

It's safe to say that there is no clear alternative. As I've blogged previously, it's more likely that more state and regulatory intervention is the defining theme. We hear more often these day about John Lewis, co-ops, mutuals etc, but it's not clear how serious politicians are about actively promoting such alternatives rather than just saying they like the idea of other ownership models. We are already seeing some renewed interest on the British left in something like co-determination, but again it's not clear that this has momentum yet (it's interesting that some businesses might like it more than some trade unionists).

But even though where we go next isn't entirely clear, I do think we look to be moving on. It looks like the 1990s is finally coming to an end in UK corporate governance.

Whilst you were looking at Europe the regulatory turn happened here

You'll recall, of course, that there is a popular narrative in the UK investment world about stupid Eurocrats meddling in stuff they don't understand. The plebs on the continent are unable to grasp the understated elegance of 'comply or explain', for example, and just want to try and 'regulate' bad behaviour or poor decision-making out of existence. That in turn means we need to defend our model against this threat by demonstrating that a market-driven approach is inherently superior to any silly ideas the EC might come up with.

What to make of this then (another excellent scoop from Sky man Mark Kleinman it has to be said)?

Regulators should be given greater powers to block hostile bank takeovers in order to avoid a future crisis like the one that forced Royal Bank of Scotland’s (RBS’s) into a £45bn taxpayer bail-out, the chairman of the Financial Services Authority (FSA) will say next week.

So we are now at the point where the FSA believes it should be able to block hostile takeovers because of potential systemic risk. This is important for several reasons, when thinking about just how market oriented our system really is. Firstly it means that regulators get to decide on takeovers before shareholders do. You might want to vote to take the cash, but the FSA might block a deal before you get a chance to. Secondly, it clearly implies that regulators think that shareholders may not spot/oppose deals that are extremely risky. Thirdly, it could come to set a benchmark, whether intended or not, of 'FSA approved' takeovers. This is not insignificant.

But there's more:

The report, which runs to about 490 pages, contains recommendations about the future of banking regulation. These include raising the prospect of bank directors being forced to prove their innocence in the event of a future bank failure; being obliged to forfeit remuneration; or toughening laws governing directors’ liability in the event that their bank goes bust.

So, potentially much tougher standards for those involved in the corporate governance of banks, including potentially changing their liability for failures. This goes a bit further than the Corporate Governance Code, doesn't it? An obvious question, and an argument that we'll no doubt hear pretty quickly from the banking lobby, is whether this will stop people wanting to become directors of UK-regulated banks.

And there's more:

In his introduction to the report, Lord Turner, the FSA chairman, argues that in contrast to the boards of other companies, directors of banks should place less emphasis on profit maximisation and more on effective risk management.

What to say? If accurate this is a fundamental challenge to the idea that we should just let businesses, even systemically important financial institutions, pursue their own interests because it ought inevitably to benefit us. It's almost a 2008 vintage mid-crisis perspective.

And there's a bit more:

I’ve learned that as part of its inquiry, the FSA wrote to former non-executives of the bank, including Sir Tom McKillop, the chairman at the time of RBS’s collapse, to gauge whether they had felt intimidated or bullied by Sir Fred’s notably autocratic style. I’m told that none of the former directors responded that they had.

I wonder if any of the large investment institutions, or their representative bodies, have done anything like this? I strongly suspect the answer is no. But, with the benefit of hindsight, it seems like such an obvious thing to do. Another indication that shareholders currently just aren't set up to play the ownership role? Whether or not that is the case, it certainly seems to be true that the FSA is playing an ever greater role in the governance of the businesses under its watch.

This is not an isolated incident. Remember, for example, that the FSA is looking into the Pru/AIA bid, and has apparently told Santander to strengthen its governance. Again these interventions are very significant because inevitably they will carry more weight than shareholders putting on pressure. This is particularly the case when any UK-listed financial institution with any smarts will know that a) there are investing institutions out there that would rather bite their own arms off than vote against and b) even where there is shareholder unease they can paly 'divide and rule'. Doesn't always work, but at least more of a fighting chance than when dealing with the regulator (bear in mind, for example, that neither chair or chief exec went from Pru despite the failed deal).

As I've been banging on for some time, we should not kid ourselves that the UK is purely-driven governance regime and should instead be aware that a more regulatory approach is already on the cards. The more I look at some of the commentary about sticking up for the UK model against EU regulatory interference the less I consider it corresponds to reality, at least in respect of listed financial institutions. And once you let regulators play a role in the governance of some sectors, why not others?

The FSA and corporate governance

Have to say I find this a bit surprising. It's not an isolated example either. It immediately makes me think that those in the UK investor community worried about the EC's possible tilt away from 'comply or explain' may be looking in the wrong place for a fight.

I think this is indicative of a much wider trende. I have been saying for a while that the likely outcome of the failure of market oversight of financial institutions would be a shift to a more regulatory approach to governance. The fact that the FSA is engaging with a bank to get it to strengthen its board is a good example of what we may begin to see more of. I'm also interested in whether/how the FSA communications concerns to investors.

Anyway, looks like the first bit of practical evidence for the regulatory turn and it's happening in our own backyard. People in the UK investment community love nothing better than moaning about ill-informed European civil servants mucking everything up, and latterly this has included corporate governance. I'm starting to wonder if that says more about their own politics than what is really going on here.

Regulating culture in financial institutions

It begins.

Hat-tip: CL&G.

A regulatory turn?

I thought I'd try and pull together a few bits and pieces that I've briefly blogged about already that I think point to a potential shift in governance, perhaps towards a more regulated approach. First, up let's return to what Stephen Haddrill of the FRC said last week about the potential for investors to be stripped of their rights. Here's a slightly longer excerpt from his speech:

In the wake of the crisis, Governments and the public at large expect [the] responsible, benign and moderating influence [of shareholders] to be maintained and intensified. Market pressures may point in the other direction; fund managers may argue that they have no mandate for engagement; pension funds may argue their members’ money should only be spent on stock picking skills; traders may see only the vital need to enhance the technology to push ownership periods below ten seconds. All are points with some validity. But if shareholders do not lift their eyes and see thatas a result of such views stewardship is weakening and needs to be strengthened, then Governments will conclude that governance must become based on law – and that is not good news for shareholders investing in companies that need flexibility to win in global markets – and the public will conclude that shareholders do not deserve their rights. That the deal is off.

As I posted previously, I think this is absolutely right and I don't think that UK institutions have really taken the point onboard as yet.

This is odd, as the warning signs are already there. I mentioned Paul Myners latest speech yesterday. Here's something he said early on that is worth flagging:

The European Commission’s Green Paper last month on corporate governance of financial institutions, an important document which raises a series of challenging questions and presages a report and proposals which are likely to shape governance thinking and practice across Europe, points to doubts about corporate governance processes based on the presumption of effective control by shareholders of listed companies. The EU Commission intends, inter alia, to review methods for strengthening shareholder co-operation, monitoring adherence to stewardship codes, addressing conflicts of interest and disclosure by end investors of the remuneration of the intermediaries. Over the last 12 months many in the UK have been wrestling with the EU Commission’s proposed Directive on hedge funds and private equity, a Directive which starts from a basic scepticism about market efficiency and agent accountability. The EU Commission’s Green Paper on Governance uses words more subtle than the original hedge fund Directive but the underlying message is very similar. The Commission is not convinced that the existing model is working and is inclined towards the need for more regulation, extended duties of care and wider stakeholder accountabilities for directors and corporate officers and a role for supervisors “to check the correct functioning and effectiveness of the board”. We have been placed on notice!

Again, very true. The EC paper (PDF) is not an explicit attack on the shareholder-focused model of governance, but there are plenty of digs, like this:

The financial crisis has shown that confidence in the model of the shareholder-owner who contributes to the company's long-term viability has been severely shaken, to say the least.

This:

The Commission is aware that this problem does not affect only financial institutions. More generally, it raises questions about the effectiveness of corporate governance rules based on the presumption of effective control by shareholders.

And this:

The Commission is also considering whether, in addition to shareholders' interests, which are essential in the traditional view of corporate governance, financial institutions also need to take better account of other stakeholders' interests.

That seems to suggest a policy shift away from a shareholder-focused model, doesn't it? And let's be honest, in political terms the UK probably isn't in the strongest position to argue in Europe that its model of public company governance is superior. As such there may will be quite a receptive audience for the Green Paper's message.

And just to finish joining the dots of this particular picture, let's have a look at what our own financial regulator in chief has to say about in whose interests the directors of companies should work. Shareholders? Err... not exactly...

I would strongly advocate intervention in the UK through changing the Companies Act framework for directors, for example. The current requirement for directors is to promote the success of the company. This is often interpreted in terms of shareholder value. Whilst this does include the need, for example, to ‘have regard to’ the impact on the community, I do not believe that is sufficient. There must be a stronger and more explicit obligation to wider society. There must be clear recognition of the need for institutions to contribute to the common good.

Once again, it's a signal of a turn away from the shareholder-as-owner model isn't it? And if directors have a wider duty to consider other stakeholders (the 'common good' would need to be narrowed down a bit) surely some people are going to start asking why only shareholders are granted legal rights to hold boards accountable in respect of those duties.

What this emerging picture means will depend on your viewpoint on company ownership generally. As a pro-market lefty I'm inclined to want to try and make progress with the initiatives we have underway like the Stewardship Code etc. I still think there are opportunities for the Left to play a bigger role here. And if we were really going to turn away from our existing model, I'd be more interested in issues like employee representation in governance rather than simply shifting to more regulation. Nonetheless the potential turn away from a market approach could be very significant, and I'm surprised that the warning signs haven't attracted more attention as yet.

Finally the silence of the Tories (both blue and yellow varieties) on these issues is surprising. It's indicative of a general lack of attention paid to governance I guess, and maybe there's also a desire not to legitimise any of Labour's work in this field. But oddly it means that the effect could again be to make it more likely that regulators gain power relative to owners in the ConDem Nation.

Myners update

Since I last posted Paul Myners has been continuing to stir things up. He gave a very interesting speech to the ICGN which I recommend giving a proper read. Notably he told (well, reminded...) investors that that it's entirely within their own power to tackle investment banking fees. It's interesting that the investment industry is very good at warning about the unintended consequences of state intervention, or regulation over self-regulation, when it affects them, but are quite keen on using the state when a different part of the system is in question.

The Treasury has also published all the responses Myners received to his letter out to institutional investors to ask them what they were doing about remuneration at the banks. These are less interesting than I expected, though some people do seem to be thinking a bit differently. I think F&C's response is worth a read (well, they do have quite a big corp gov/SRI team), but I also thought Royal London provided an interesting reply. Wooden spoon must go to Lazards (PDF) - check out the hand-scrawled whinge at the bottom. Financial Muse blog (part of Financial News, the best financial trade mag by far IMO) has already given it a bit of a piss-taking.

Finally, Myners is also quoted in this piece in the Grauniad calling on the FSA to have a look at shareholder engagement. Amen to that. I get the impression that this idea has dawned on a few people of late - where is the corp gov function in the FSA? It really does need some kind of internal resource for these kinds of issues.

In fact the Grauniad article is worth a read as a few interesting comments. Even the one right at the end, which I disagree with, but does at least restate the conventional wisdom:

"The value of a company is directly linked to the performance of managers, whether high or low. If the share price is languishing, that surely tells you that management aren't doing a good job."

Links...

1. Canadian shareholder activists SHARE have published their annual manager voting survey (PDF)
2. There's a big push for support going on in respect of the resolutions at BP and Shell on tar sands.
3. Brendan Barber blogs on M&A. I think policy interest in this area is going to increase again.
4. FSA commentary on hedge funds is interesting, and doesn't actually surprise me.

FSA tackles one argument against activism

Just a quickie, but I see the FSA has written to the financial trade body collective the ISC to make clear that it sees nothing in the Walker Review's call for more shareholder engagement that is a regulatory problem. To be honest I've always thought this was a rubbish argument against activism and one that I assume some fund managers deploy to explain away a lack of activity. (A bit like the time a fund manager told me they couldn't disclose voting data publicly because it was legally impossible. They disclose now, strangely). Anyway, if that was the substance of such 'concerns' then the FSA has just shot that particular fox.

So just to be absolutely clear this is what they say:

we do not believe that our regulatory requirements prevent collective engagement by institutional shareholders designed to raise legitimate concerns on particular corporate issues, events or matters of governance with the management of investee companies.

More broadly if a fund manager doesn't want to do all this engagement stuff I don't see why they don't just say so rather than trotting out disingenuous arguments for why it's problematic. Unfortunately there are plenty of clients who aren't interested easier. And those that are bothered can take that bit of the job off you and do it themselves.

Bonus bashing

Looks like some sort of government intervention in respect of bonuses could be in the pipeline. Alistair Darling has given an interview to the Sunday Times with some interesting comments. Given last week's leak then back-peddle, it's hard to know exactly how seriously to take this, but given that these are direct quotes from Darling there must be something in it. The key comments appear to be these - 

“If we need to change the law and toughen things up, we can do that. I’m quite clear that some of the problems we have today were caused by the fact that some traders were incentivised to take risks which neither they nor their bosses fully understood,” he said.

Darling said: “The public is rightly concerned because the taxpayer has had to stand behind a number of these banks, and the whole banking system, in effect. So people want to make sure we don’t get ourselves into this situation again. The FSA code is only part of our approach.”

Darling said: “I am not against bonuses where you are rewarding good behaviour and long-term growth. What you can do is make sure you don’t get yourselves into a situation where firms actively have a pay system that results in them being exposed in a way that led to ruin.”

There's not a lot of meat in there but I think we can draw something from this - something in addition to the FSA code is planned, and any intervention is likely to focus on bonuses and ensuring that they are paid over the long-term and/or encourage long-term performance. There's nothing in here about quantum, which is what the public is really annoyed about. That's not to say the Government isn't thinking about that too, but that isn't what Darling has said. 

And in effect, Darling could be 'tougher' than the FSA by taking its code and making it, or reporting on it, mandatory in some way. A tweak to the Companies Act could be used to make further disclosures on remuneration mandatory for example. I doubt it would have much impact in practice, but it does demonstrate that there are things that could be done which would be direct government intervention, and tougher than the FSA's stance so far. (It's worth noting by the by that for all George Osborne's rhetoric about the FSA's code being insufficient, the apparently Tories didn't bother talking to the regulator about what it was doing.) 

One final thought on this stuff. Let's take another look at my favourite quote:

"I'm clear that executive pay is a matter for boards and shareholders, not for governments and regulators."

Well as things stand the regulator is already involved. According to this latest interview the Government may itself intervene directly (and we can safely assume it has been involved behind the scenes in the meantime). The one group that sticks out for its lack of activity/involvement is... errr... the shareholders. If (and I still think it's a big if) remuneration policy did drive behaviour that contributed to the crisis then it must be in the self-interest of at least long-term shareholders to make sure that the problems are sorted. Yet as I pointed out previously, the ISC said nothing at all about remuneration in its response to the crisis. I haven't seen any statements either from the likes of the ABI and NAPF (though to be fair both did respond to the FSA consultation).  

In practical terms too, let's keep a sense of perspective - only four companies have been defeated on remuneration votes this year and only one of them (RBS) was a bank, where UKFI puled the trigger. So to date the only defeat for a bank has been driven by the Government too. The right to vote on remuneration policy was only enshrined in 2003, yet in 2007 and 2008 not a single company was defeated on its remuneration report. (And there are fund managers out there that even now barely vote against anything. I was looking at the voting record of one manager the other day - in the whole of 2008 it opposed management in less than 1% of cases. Such managers, I humbly submit, are part of the problem.)

Is it any wonder then that there is a sense of exasperation at the failure of institutional shareholders - who are very quick to assert and defend their rights - to shoulder any responsibility as owners of companies. The lack of engagement in the deeper issues in the remuneration debate is just another example of how flawed the current system is. 

Interesting comment from the ABI

In the FT today about the FSA code on remuneration:

"Care needs to be taken to avoid reading across from banks to insurers and asset managers, whose businesses are substantially different and pose much less risk to overall financial stability."

The FSA doc released yesterday shows that the ABI responded to the consultation. But which hat did they wear when writing it - the one representing insurers as companies that might get caught by the FSA code, or the one representing insurers as investors who need to have confidence in the remuneration policies in place at BOFIs? It's not that easy to do both.

The quote suggests that the ABI is thinking about the impact of the code on insurers as insurers. As I blogged yesterday, it doesn't look like any individual asset managers responded to the FSA consultation, but a number of the parent insurers that sit behind them did (Aegon, Standard Life etc). Again it seems that the interests of the insurer as insurer, rather than as institutional investor, get priority. And there's going to be a similar conflict in terms of responses to the Walker Review.

Of course this is all entirely reasonable from one perspective. I obviously wouldn't suggest that the ABI shouldn't lobby on behalf of its members as insurers (and listed companies). But it does point up the conflicts of interest that potentially inhibit more robust shareholder engagement. And to hammer the point home - the ISC, as a collective of trade bodies, has this problem multiplied by four.

FSA remuneration code

So, it's out. I'll leave the analysis of what the FSA has actually changed to those with a bit more knowledge than me. A few observations of my own though. First up, here's what the FSA says about the role of shareholders in Chapter 2:

Market discipline has not been effective in limiting the adverse effect of poor remuneration practices on risk management, particularly at large systemically relevant institutions. In many cases shareholders have allowed management to introduce compensation policies that in effect subordinate the interests of shareholders to those of employees, particularly senior employees engaged in trading businesses.

This is true, but as we know things have all changed now. This can be seen by the heightened engagement by fund managers with BOFIs over remuneration. Of the list of 17 BOFIs listed by Walker, there have been serious shareholder revolts over remuneration this year at RBS, and.... err.... that's it. And that was primarily driven by the state via UKFI.

Nevertheless we can see the importance accorded by fund managers to getting remuneration policy right by the number of them that seem to have responded to the FSA's consultation (see annex 1):

err...

Forget that. We know that the industry is planning to up its game in this area because of what the ISC - the peak body for institutional shareholders - said specifically about remuneration in its statement issued in response to the crisis:

err...

FSA and pay

Lots of speculation this morning that the FSA is going to take a softer line on remuneration policy at BOFIs than originally planned, though nothing on the website yet. The FSA code is due this week so presumably this is a bit of expectations management by the regulator. The broad argument seems to be that the FSA can't risk taking a tough line elsewhere if other regulators don't as this could lead to 'talent' moving elsewhere.

I'm sympathetic to the FSA's argument, expressed by Hector Sants in the FT today, that remuneration policy was a relatively minor contributory factor in the crisis. But the argument about the risk of taking too tough a regulatory line damaging our competitiveness was one of those that got us into this mess in the first place, wasn't it?

FSA extends shorting disclosure regime

Via the extremely informative Corporate Law and Governance, I picked up the news that the FSA said on Friday that it was extending the shorting disclosure regime again. The full policy statement is here (PDF).

I'm actually a bit surprised by this. The FSA says that the decision was taken "to minimise the potential for market abuse and disorderly markets in UK financial sector stocks". Yet as I blogged previously the FSA's previous discussion paper on shorting was pretty positive about the practice, arguing that it delivered market benefits.

The other interesting thing to note in the latest statement is the support for the extension of the disclosure regime from 4 'trade associations' (see pages 4 and 5). Based on the list of respondents, and assuming that the likes of the ISLA and AIMA are opposed, it looks likely that the more 'traditional' investment lobby groups were in favour. This is no great shock in one sense, as I am pretty sure the ABI have said as much publicly, but what does it say about their implicit views about how markets operate? Or is it 'long-only lobbying'?

Pay again

This is from the Turner Review and is pretty close to what I was saying yesterday:

Excessive risk taking, at least at the top management level, may be driven more by broad behavioural and cultural factors than by a rational consideration of the precise incentives inherent within remuneration contracts: dominant executive personalities have a strong tendency to believe in their own strategies.

FSA reading list

Just a quicky on the Turner report. The footnotes to the 'fundamental theoretical issues' section actually provide a pretty good reading list for understanding why things may have gone wrong. Many of them are quite easy reading (I found Stablising an Unstable Economy required quite a bit of concentration, but maybe that's just me), which means that it shouldn't be too much of a challenge for any interested lefties to get up to speed pretty quickly. And obviously I think more of us ought to be doing this.

Here's the list -

John Maynard Keynes - General Theory (1936).
Hyman Minsky - Stabilising an Unstable Economy (1986).
Charles Kindelberger - Manias, panics and markets (1978).
Robert Shiller - Irrational Exuberance (2000)
An institutional theory of momentum and reversal - Vayanos and Woolley LSE, (November 2008).
George Soros - The new paradigm for financial markets (2008)
Kahneman, Slovic and Tversky - Judgment under uncertainty: heuristics and bias(1982)
The Great Contraction in Friedman and Schwartz - A monetary history of the United States 1867-1960 (1963).
Benoit Mandelbrot - The Misbehaviour of Markets(2004)
Nassim Nicholas Taleb - The Black Swan: the Impact of the Highly Improbable (2007)
Andrew Haldane - Why banks failed the stress test (February 2009)
Frank Knight - Risk, Uncertainty,and Profit (1921)
Adair Turner - Uncertainty and Risk: reflections on a turbulent year
Daniel Tarullo - Banking on Basel (2008)

It’s FSA day

Not only do we have the Turner Review (PDF) to enjoy, but the regulator has also issued a consultation paper (PDF) on remuneration.

I’ll give the Turner Review a proper read over the next few days, but I have had a quick skim of the ‘what went wrong’ section. Not surprisingly I was drawn to the commentary on the rationality (or otherwise) of financial markets, which is explored as part of the discussion of whether the assumptions underlying the previous regulatory regime were sound. This bit is well worth a read, and it is not overly techie reading. Robert Shiller’s work on markets rightly gets a few plugs.

Here’s the core:

In the face of the worst financial crisis for a century, however, the assumptions of efficient market theory have been subject to increasingly effective criticism, drawing on both theoretical and empirical arguments. These criticisms include that:

• Market efficiency does not imply market rationality. There is nothing in empirical tests of market efficiency narrowly defined (i.e. tests of the non-existence of chartist patterns) which illustrates market rationality. The fact that prices move as random walks and cannot be predicted from prior movements in no way denies the possibility of self-reinforcing herd effects and of prices overshooting rational equilibrium levels.

• Individual rationality does not ensure collective rationality. There are good theoretical and mathematically modellable reasons for believing that, even if individuals are rationally self interested, their actions can, if determined in conditions of imperfect information and/or determined by particular relationships between end investors and their asset manager agents, result in market price movements characterised by self-reinforcing momentum.

• Individual behaviour is not entirely rational. There are moreover insights from behavioural economics, cognitive psychology and neuroscience, which reveal that people often do not make decisions in the rational front of brain way assumed in neoclassical economics, but make decisions which are rooted in the instinctive part of the brain, and which at the collective level are bound to produce herd effects and thus irrational momentum swings.

• Allocative efficiency benefits have limits. Beyond a certain degree of liquidity and market completion, the additional allocative efficiency benefits of further liquidity and market completion may be relatively slight, and therefore easily outweighed by additional instability risks which increasing liquidity or complexity might itself create. It is for instance arguable that the allocative efficiency benefits of the creation of markets for many complex structured credit securities (e.g. CDO-squareds) would have been at most trivial even if they had not played a role in creating financial instability.

• Empirical evidence illustrates large scale herd effects and market overshoots. Economists such as Robert Shiller have argued persuasively that empirical evidence proves that financial market prices can diverge substantially and for long periods of time from estimated economic values, with the calculated divergences at times so large that policymakers can reasonably conclude that market prices have become irrational.

Music to my ears, and no surprise that the FSA concludes that:

the acceptance that financial markets are inherently susceptible to irrational momentum effects does imply that regulatory approaches should be based on striking a balance between the benefits of market completion and market liquidity and the potential disadvantages which may arise from inherent instabilities in liquid markets.

And skipping forward a bit, there are some interesting comments about the failure of market discipline to sound the alarm about problem companies –

• Bank CDS prices before the crash of 2007 did not provide forewarning of the scale of problems ahead. They were moderately successful in indicating the relative riskiness of different institutions – e.g. suggesting that Northern Rock was more risky than other banks. But their overall sector wide level suggested that risks were at historically low not historically high levels.

• Bank share prices similarly failed to indicate that risks were increasing, but rather delivered strong market price reinforcement to management’s convictions that their aggressive growth strategies were value creative.

Obviously I’ve just focused on a couple of sections of the report that interested me. I may post up some further comments once I’ve had a proper look.

Turning to the remuneration consultation doc, early on the FSA (rightly in my view) makes clear that you can’t draw a causal link between rem policy and inappropriate risk-taking behaviour, but...:

there is widespread consensus that remuneration practices may have been a contributory factor to the market crisis. Practices in common use during the period leading up to the crisis, mainly but not exclusively in investment banking, tended to reward short-term revenue and profit targets. These gave staff incentives to pursue unduly risky practices, for example by undertaking higher risk investments or activities which provided higher income in the short run despite exposing the institution to higher potential losses in the longer run.

Again I went hunting for the section I'm most interested in, this time the role of shareholders. It turns out there is actually some discussion of the short-termism of shareholders, and how this can result in inappropriate remuneration arrangements being adopted. Get a load of this:

The interests of shareholders with a focus on short-term profits are not aligned with those of long-term shareholders. They are further not aligned with the interests of society as a whole, as they do not take into account the wider consequences of excessive risk-taking. Shareholders with a focus on short term profits can include employees of the firm who are participants in share incentive schemes, which often mature in a relatively short period of time. Pressure from shareholders with short-term perspectives is one factor why remuneration packages geared towards the short-term and leading to excessive risk-taking are offered to employees in the banking industry.

So they say:

Regulation of remuneration structures is a countervailing power to the influence of shareholders with a short-term focus and reduces the negative impacts of shareholder short-termism. It removes the power of shareholders with a short-term focus to impose remuneration structures which are in their interest, but not in the interest of long-term shareholders and society.

Again, I have to say I’m greatly encouraged by the direction in which things are turning. I’m almost feeling… optimistic.

Sants highlights investors' role in the crisis

Interesting intervention fro the FSA chief exec. This may be the thin end of the wedge.

FSA chief executive Hector Sants has said pension funds must shoulder some of the blame for the financial crisis and will play a crucial role in any recovery.

Speaking at the National Association of Pension Funds investment conference in Edinburgh, Sants called on pension funds to help avoid future financial crisis by taking a far greater role in checking on management performance and risk in companies they owned.

He said: "I have questioned whether, if there had been more effective and collective shareholder intervention whether the financial crisis we are witnessing today would be as severe."

He also said investors had, in future, to make sure they understood what they were investing in.

"You have a major role in addressing the issues arising from this financial crisis," he told delegates.

"As owners we would encourage you to focus on the issues of governance, risk management, business strategy, and the issue of compensation."

He said in order to do that pension funds would have to engage more actively with senior management and non executive directors, but that ultimately funds had to organise themselves more effectively for collective action.

One audience member described Sants suggestion that pension funds should be at least partly blamed for the financial crisis as "staggering" and asked Sants whether the regulator should have done a better job in ensuring the information coming from companies was of a better quality.

Sants agreed that more could have been done in this area, and said the FSA had already accepted it had been partially at fault. However he said there had been a "laziness in the system in the use of credit ratings agencies" suggesting that investors had become too reliant on them.

NAPF chairman Chris Hitchen commented: "It is not our job to manage companies. We can only set a framework about what we expect from the companies we own."

He added: "In the future executives of companies will have to wait longer for remuneration, which will bring them in closer alignment with with the owners."

From Professional Pensions

John McFall tells FSA to keep an eye on shorting

Shorting ban ends, banking stocks go mental. Here's what the chair of the Treasury select committee has said to the FSA in an open letter to the regulator:

In the light of the extreme market turbulence in bank shares in the week since the ban was lifted, could you please confirm that the Financial Services Authority is actively monitoring the connection between the volatility in bank shares and the repeal of the ban on short selling. I am particularly concerned given that I have heard disturbing anecdotal evidence that some hedge funds have been shorting stocks in UK banks. To this end, could you also please confirm that you will not hesitate to re-introduce the ban if it is found that short selling has contributed to the undermining of stability in the banking sector.

FSA and shorting again

Actually, I didn't read this properly Monday. The FSA is going to extend the disclosure of short positions in respect of the banks until June, plus it will be issuing a paper shortly setting out its plans more broadly in respect of shorting. Could be interesting.

For what it's worth I reckon investors (say ABI, IMA, NAPF) ought to fund some serious research into the impact of shorting, looking at issues such as volatility and price formation. It may well be that there is no case to answer, and to be honest I am leaning to the view that shorting is more a waste of money than anything else, but at the moment the debate seems to take place with very little evidence. So why not get the big investors to cought up some cash to fund some decent analysis?