Post-covid capitalism: Let’s talk about risk
Who exactly is taking what risk and bearing its consequences, asks Mike Clark
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As individuals, we manage risks every day. As investors, we manage risk in a particular way. And we expect governments to manage many risks: building regulations, food labelling, flight safety and many more. They protect us as citizens, and frame the risks we manage as investors. What has the Covid-19 crisis taught us about risk management, both as citizens and as investors?
Let’s start with governments. They know they will have to up their game when it comes to risk management. Voters will require it. Work is needed on policies and practices that identify and then manage risks, particularly high impact risks, even if they are low probability. Paying insufficient attention to such risks will become less acceptable. The shock of the Covid-19 crisis will reverberate for a long time. It is clear that some citizens have fared much worse than others. Key workers, often in low paid jobs, have demonstrated their worth to all of us. Risk outcomes can have a very immediate political effect.
Governments – and financial regulators – have acted in a way that would have been regarded as well-nigh impossible 12 months ago. Equity warrants have been issued by US corporations to their government. In the UK, the Bank of England made it clear that UK banks should not pay the dividends they were planning. The EU is placing conditions on their provision of financial support to companies. The rules of the game have changed and our previous risk assumptions – often very deeply held – need to be revisited.
When investors in lower-credit bonds have taken a risk which later results in a capital loss, what type of capitalism is it where the Fed bails them out?
Some risks are given insufficient attention, and pushed back for possible future consideration. That doesn’t lessen the risk. It simply means that when these risks crystallise into an event, we realise, rather too late, the costs we are now incurring. Economics readily classifies some activities as externalities. The standard example is the polluter lowering their costs by dumping their waste and making it someone else’s problem. It can be helpful to view the deferral of managing risks as creating externalities. So if we assume that governments will both identify risks and deal well with the bad things that happen when such risks crystallise, but they don’t or cannot, what does that say about the relationship between citizens and government? We have delegated risk management to governments, but sometimes they do not do the job we expect. We might call this the Great Risk Black Hole. These risks fall back on us, the citizens.
One of the challenges is that governments are too often seen as the solution to every problem. We assume they will deal with any really bad outcomes. Rightly, governments have recently hurried to give financial support to their citizens. But when everyone turns to government to solve their own particular problem, what does that say? Too easily, we see governments as the ultimate risk bearer. But when investors in lower-credit bonds have taken a risk which later results in a capital loss, what type of capitalism is it where the Fed bails them out? Or when governments flirt with the notion that insurers should meet claims arising from risks they did not underwrite, what does that mean for risk pricing? Capitalism leans heavily of the principle of the fair pricing of risk, both in capital markets and in insurance. It is clear that, collectively, we are overlooking this important risk principle too often.
What does this mean for investors? If the current crisis shows that governments’ risk management has been weak, investors seem likely to revisit some of their own risk assumptions. Asset owners, the long-term investors sitting at the top of the investment decision-making process, will be encouraged to pay more attention to managing some of these systematic risks themselves. Climate change provides a useful pointer. Leading asset owners are leaning away from mispriced climate risk in their investment strategies. It is widely agreed that governments are moving too slowly on climate policy. So these asset owners are also getting more vocal in their engagement with policymakers and financial regulators.
How does this strategic risk management by asset owners fit into standard finance theory? With difficulty. When we ask this question we are asking about real world risks. Standard finance theory offers us tools such as alpha, beta, CAPM, efficient market theories and tracking error. In all this, beta, market risk, is treated as a given. But if an asset owner can start to choose which real world risks - and thus which capital market risks - they will take, beta becomes a choice, not a given. The asset owner has begun to select their desired capital market risk exposures. Asset classes as we know them have less relevance. We also observe how asset owners are managing their risks strategically through the exercise of ownership rights. The collective engagement of Climate Action 100+ is investor capital influencing companies’ risk management.
There is some irony in asset owners influencing government policy and financial regulation. Asset owners can tend to disparage corporate lobbying of government. But surely we should expect companies to lobby government to favour their interests. Why would they not? We then realise that asset owners have a very weak political voice, whilst companies and their industries see lobbying as a key skill. This often means advocating for the status quo, and we only have to look at fossil fuel companies’ lobbying to see that. Let’s encourage more asset owners to have a Head of Government Relations.
On this path, asset owners have started to commission research to help them manage the strategic risks of climate change. The Inevitable Policy Response initiative seeks to forecast the evolving global climate policy landscape. Asset owners need real economy research as they learn they can no longer leave risk management to the investment managers they appoint. What’s next? Inequality would be on my shortlist.
We need to consider the traditional approach to Strategic Asset Allocation (SAA), rooted in finance theory. But if SAA struggles to incorporate the risks which asset owners are now seeking to manage, it is deficient. So before we get to SAA in the investment decision making process, asset owners need to spend some time on a Strategic Risk Management (SRM) process. Is climate change the only systemic economic risk that asset owners might wish to manage? No. Asset owners are devoting more resources to voting their proxies and engaging with companies on key issues, managing the risks they view as strategic. We can begin to talk of investing for a world worth living in.
Asset owners have a very weak political voice, whilst companies and their industries see lobbying as a key skill… Let’s encourage more asset owners to have a Head of Government Relations.
With this heightened risk perspective, we will revisit some of the fundamental practices in finance, and the beliefs and assumptions that surround them. For example, we see debt and equity as different types of capital. But risk lies on a continuum, running from an AAA rating through junk bonds to equity. So our packaging of risk in different types of securities is simply a convenient construct. Now, debt invariably plays a large role in an economic crisis. This time is no different. We can ask if the world’s economies have expected debt to play too big a role in finance. Are we trying to run the world’s economy with too little equity, with too little truly risk-bearing capital? If debt starts behaving like equity in a crisis, the answer is probably Yes, we are. Equity provides resilience in a way that debt does not. We can then ask why does society incentivise equity-type risk to be packaged as debt, by offering favourable tax status? We are already questioning the practice where a company has issued debt to pay for share buybacks when soon afterwards the company turned to the government for assistance. Who exactly is taking what risk, and bearing its consequences?
Elsewhere, does too much of the success of private equity – with commensurate rewards for those involved - stem from the tax deductibility of debt? This can lead us to ask how does society view an employee’s unemployment risk in a highly leveraged company with low resilience? Have companies with employees on zero-hour contracts transferred too much risk to the state, with governments underwriting the costs which previously companies would have absorbed? Do the low interest rates over the past decade simply inflate asset prices in an unsustainable way, without achieving the policy goal of increased aggregate demand? Investors will be asking more questions about issues they previously avoided because they were seen as out of scope and political.
Finally, let’s try a thought experiment. Consider the trustee of a pension fund who has a parent in a care home. The pension fund’s trustees appoint an investment manager. The investment manager invests in a portfolio of care homes, gears up with debt in order to leverage investment returns and simultaneously encourages the care homes to reduce resources and thus the quality of care, in order to boost those investment returns. After a trustee meeting, the trustee visits their parent who tells them, sadly, that they are suffering because the care has worsened over recent months. Are the trustee’s actions consistent with the wider needs of society?
The covid crisis, building on what we have already learnt about climate, is a helpful teacher about risk. How will capitalism evolve in the direction of better risk management? I hope this article offers investors a few pointers.
Mike Clark is Founder and Director of Ario Advisory