Global financial crisis: how many wake-up calls do we need?

Raj Thamotheram and John Fullerton outline what they believe are the 10 biggest mistakes by investors on the financial crisis.

There is an old Arab saying which goes something like this: if your tent in the middle of the desert is hit by lightning, don’t worry, it will never happen again. If your tent is hit twice, then move it! Four years on since the global financial crisis started, it is now arguably in an even more dangerous phase. So now would be a very good time for the members of ICGN & UNPRI to take stock of what they have done to be part of the solution – not the speeches and events – but the real actions and actual achievements in order to safeguard their big, investor-filled tents. The context is clear, albeit uncomfortable. As the noted (US) economist Adam Posen, member of the Bank of England’s Monetary Policy Committee and of the Panel of Economic Advisers to the US Congressional Budget Office and senior fellow at the Peterson Institute for International Economics, said at the Just Banking conference in Edinburgh in April: “One of the great failures of this financial crisis was that large institutional shareholders did not exercise their voting rights and responsibilities”. The Bank of England Monetary Policy Committee isn’t known for being a hot bed of revolutionary fervour! Of course, Posen was just saying what most informed and independent commentators know but generally don’t say, at least so clearly. Whatever else the crisis was due to, there is no doubt that massive failures of corporate governance allowing banks to act irresponsibly contributed enormously to market dysfunction. So investors, alongside regulators, the financial media and economists messed up. The question is what have we learnt and what are we now doing? Learning from failure can be immensely productive. It’s something the financial world hates to do but it’s time to grow up, do so, and move forward, regaining our credibility and license to operate in the process.So what were our biggest mistakes? Here’s our list of ten:

  • We encouraged – certainly passively, if not actively – banks to pursue risky and suspect products and strategies. Consumer watchdogs raised the alarm about PPI in 1998 and the FSA issued its first report in 2005 many years before this became a matter of investor concern. Did any finance analyst really not understand the risks of NINJA (“No Income No Job or Assets”) mortgages?
  • We tacitly encouraged banks to over-leverage on debt. As some banks have commented, when they met investors pre financial crisis the message was often: “why are you being so financially timid?”
  • In practice, we judged future performance based solely on past performance. How else could investors have approved the mad RBS takeover of ABN Amro?
  • We approved pay designs which incentivised dangerous risk taking and “too big to fail” growth. We were, in the immortal words of a well-known UK politician “intensely relaxed about bankers becoming filthy rich” (and we didn’t even care too much if they paid tax).
  • We failed to get the sell side/credit rating agencies to analyse banks’ corporate governance and didn’t adequately resource independent research houses to do such analysis, or indeed pay much attention to those that did and who came up with worrying answers.
  • We didn’t use our ownership rights to ensure boards were experienced and independent enough. Nell Minow, co-owner and board member of GMI Ratings, summarises the situation well when she says: “Lehman Brothers had a board that included an actress, a theatrical producer, and a retired admiral — and no one who understood the complex securities that lead to their implosion.”
  • We relied too heavily on the (inadequate) risk models of banks (Value at Risk or VaR) and didn’t invest in risk management models that we needed given our systemic exposures.
  • We didn’t appreciate the systemic risks presented by the shadow banking system.
  • We maintained excessive exposure to a high-risk sector because of cap weighted indices.
  • We did our usual trick of keeping our heads down and being wilfully impotent in public policy debates, thus allowing the banking lobby to set the agenda and capture regulators/politicians.

We have shared this thinking with many in the sector and have not heard anything that has caused us to consider this a mis-diagnosis. You may have a slightly or even very different list (if so, please tell us). But the only failure would be to be so in denial as to have no list. So the really important question is what are we doing differently today? Most people don’t like to answer that question in public and when they do, it’s the institutional blah blah. Minow is different. Focusing on J P Morgan, we asked her what investors were doing better now and where they needed to improve. Her simple answer was that nothingmuch has changed. It is well documented that regulatory response after regulatory response is watered down as a result of push-back by powerful bankers against (in general) weak/frightened/captured politicians and regulators. Positive deviant insider voices like FT columnist and economist Martin Wolf, Hector Sants, CEO of the UK Financial Services Authority, and Paul Volker, the former US Chairman of the Fed, have alerted us to this happening in real time. It’s not that we don’t know it’s happening. So where in all of this are the voices of the long-term fiduciaries? Between us, we monitor the news quite closely in the US and EU but we have not heard one single major institutional investor engaged in the debate in a way that might have any real influence. The only time investors have raised their voice is to lobby with the banks against the Financial Transaction Tax. Whether this tax is the cure that advocates claim against excessive trading is a subject for another article. But given how damaging the hyper volatility we face today is to the interests of the end beneficiaries, it is frankly astonishing that investors are lobbying against a proposed solution without saying what they do want. Indeed a recent letter in favour of a mild version of the tax, which was even signed by ex-bankers in the US and EU, has failed to get the support of even one PRI or ICGN asset owner or mainstream investment manager decision-maker. Back in October 2011, one of us proposed, in an article on RI, a collaborative investor engagement initiative focused on the banking sector: Link to article Despite the growing emphasis on engagement and even a PRI clearinghouse to coordinate efforts, nothing of the kind has yet happened. At the Just Banking event, there were only two professionals from Scottish pension funds and investment managers! Bravo to these 2 contrarians. But what does the lack of investor presence – SRI and corporate governance community included – at a major event on the banking sector say about the institutional investment community’s
willingness to engage with well-informed stakeholders? For this reason we say that this failure to learn and adapt is probably the biggest failure of fiduciary duty that our profession has ever seen; even worse, we would argue, than the original mistakes. Of course, it is hard for individual institutions to act in isolation given all the conflicts of interests and sensitivities in the finance world. Luckily we have two very powerful representative organisations, the International Corporate Governance Network (ICGN) and the United Nations Principles for Responsible Investment (UNPRI), which together account for 10-20% of the institutional investment world. Their establishment and growth has been a great achievement and both are vital for investors to coalesce around and move towards finance that is long-term sustainable. However, what is now required to reach the proverbial “tipping point” is collaborative leadership. And leadership is the ingredient that has been seriously lacking to-date. Simply building the gun is not enough if all it turns out to be is a water pistol. Travelling to Rio at this time of great economic hardship for millions and huge systemic risk is a brave choice. But it will have been the right one if the directors of ICGN and PRI make use of their private and public meetings post the Rio+20 event to find ways around the governance weaknesses in order to address the challenges described above. The CFA Institute could be a good role model. It, too, is constrained by its diverse membership and conservative history. But rather than do nothing or pretend that the current regulatory response is largely ok – which is what one senior ICGN official said at a conference that one of us recentlyattended – it has partnered with a leading foundation to set up an alternative regulatory watchdog agency, the Financial Services Oversight Council, led by highly credible insiders: Link There is a potential for distraction in detailed debates about “what” we should focus on and “how” to react the financial crisis. Once they know their CEOs and CIOs are serious about sorting out the situation, traditional analysts and ESG specialists will, together, work out the best answers and they can call on a significant number of academics, retired bankers and regulators for specialist advice. Some obvious priorities would be to: lobby governments to act together to decrease leverage significantly; tighten up on executive pay and do this at the same time in all markets; and significantly boost risk functions in all key financial situations. We will come back to the action list in a more detailed way in our next article and would welcome your ideas about priorities. However, today the critical missing ingredient is the “why”; the awareness of imperative of action on the scale needed. For that we need to allow ourselves to be dissatisfied with what we have managed to do to-date and not pretend it’s been the best we could have done. Members of PRI and ICGN owe it to the pension fund members and retail customers they serve to come back from Brazil with this intent much more clearly in their “Monday morning” minds. If this doesn’t happen, who could blame the public if it loses complete trust in our ability to “move our tent” and avoid the next financial sector “preventable surprise”.
Raj Thamotheram is Co-founder at Preventable Surprises , and John Fullerton is President and Founder of the Capital Institute in the US