Governments want more activism while the public shareholder base crumbles

Changing financial markets for the better will require protecting the DB base of active investors.

Chuck Prince, the former CEO and chairman of Citigroup’s infamous dancing quip will probably live to become one of the defining statements – or perhaps understatements – of this financial crisis. In the face of growing turmoil in the US sub-prime market, Prince told reporters in July 2007: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” Prince, of course, quickstepped off with pay and perks believed to be in the region of $100m despite his tenure leading to tens of billions of dollars in write-downs and a halving of the Citi share price in the year before he left, and further subsequently. And his ‘complicated’ didn’t really come close to describing the financial meltdown that ensued when market liquidity froze and stayed solid. But what the quip incarnates is the cultural or systemic market ‘mood music’ most of us were caught swaying to prior to the crash: a medley of high, unchecked borrowing, poor governance, compromised ratings and audit processes, untenable return expectations, greedy compensation systems, flaccid regulation and unchallenging market perspectives from regulators, investors and the media.Few quibbled with the tunes when the party was good. Part of the incessant, and justified, blood-letting about bank bonuses at the moment, is, I think, a reflection of some of the collective guilt we bear that things could have gone so far wrong: that mortgage lending could have been so slack, some derivatives so dangerous to the wider economy, bank capital so fragile, governance across the board so poor. It would take several books to do justice to where it all went awry and to apportion blame. The touch-paper for public anger, and that of shareholders alike (albeit mostly after the fact), is that bankers and, dare we say it, some asset managers can still pocket ‘bonuses’ (and, of course, in former RBS chief Fred Goodwin’s case, exorbitant pensions) even if the very existence of their company is predicated on government bailout. That cannot be right. These are dark, difficult days for investors trying to protect decimated asset bases and the investment industry to hold on to clients and their jobs. But they could herald even more serious long-term pain if we are not careful. Financial services companies should not, I think, underestimate the damage the ongoing crisis is having on long-term public confidence in savings and investment. That will

need to be rebuilt. We believe part of the healing process could be for investors and fund managers to take a ‘hippocratic’ oath saying they are financially, socially and environmentally friendly: ‘fair-trade’ trading if you like. We also underestimate at our peril the mortal damage that may have been already done to the defined benefit (DB) pensions system as a result of a lack of decades of regulatory protection combined with today’s yawning capital deficits as a result of the crunch. For those who believe in the DB values of risk sharing, collective purchasing power and the ability of pension funds to act as responsible mediators in the capital markets system, the long-term effects could be catastrophic. Those who herald the advent of defined contribution (DC) plans as a response to the withering of DB might want to factor in a 40-50% savings loss for individuals just prior to their retirement date and see if that washes socially. Both the advent of DC and the wholesale buyout of pension schemes by specialists and insurance companies – particularly attractive to cost-sensitive corporate finance directors at the moment – also raise the question about the role of the shareholder in an atomised (DC) or closed (pensions buy-out/buy-in) investment world. The much-mooted concept of ‘fiduciary’ management by investment managers and consultants appears, for the moment, to be much more about asset gathering and control than anything particularly ‘fiduciary’ as far as I can see.
This feeds into a worrying quandary. Governments and regulators both nationally and internationally are moving necessary and often belated rule changes forward, while keeping one eye on the real-politik that dictates that over-regulation could prompt financial companies to go elsewhere. They expect shareholders to take upthe slack: more vigilance on executive pay, governance, and pushing companies to be more transparent on their social responsibility (see recent RI stories on Paul Myners and Dutch Tabaksblat rule changes). This will be hard if the number of recognised active shareholders, as we now understand them, is dwindling steadily because of the erosion of DB. We should also factor in the trend that increasing numbers of institutional investors say they are moving to private markets (venture capital, private equity) where corporate engagement on all levels takes place away from the public gaze, throwing up serious questions of transparency just at the moment when governments are trying to shine a light on financial market activities. In addition, there is a danger that legislation is poorly made on the hoof. Institutional investors should feed into this process now, but they will need to have their argument straight on what they mean by long-term investment (long-term mandates anyone?) and good governance in public markets and demonstrate that they are doing it.
These are debates that must be had, and which we will cover in RI because we believe they underpin the very notion of investment and social responsibility. In their defence, investors have made some potent responses to the crisis. We think the most searching of these have come from the SRI community. The Network for Sustainable Financial Markets continues to issue illuminating papers that respond to the core failures – derivatives, governance, systemic risk – that led to the crisis. Eurosif is leading the charge on CSR and transparency issues at the EU, while its sister SIF in the US corrals investors to petition President Obama on say-on-pay and corporate governance. The recent statement

by the UNPRI that investors need to take some of the blame for the credit crisis, should not, in my view, be taken negatively, but as a realisation that institutional investors can shape the financial system for the better should they choose to. This market crisis that has blown away as much as ten years of returns did not come out of nowhere. In response, investors must take responsibility for deciding what are sustainable and unsustainable returns, both financially and socially, for the future. That has not always been the case in the past. Unless we work hard to put rational, practical solutions forward, sustainability risks becoming a crisis buzzword ratherthan properly embedded in the financial system to guarantee steady future employment, corporate growth and decent retirement to which boom and bust on this scale is anathema. The old saw goes that after the war, everyone is a member of the resistance. Few now question the urgent need to repair the bombed-out financial sector and many say it never should have got to this point. But that zeal will not last. For those who believe that markets can be changed for the better, it’s important to look forward, seize the moment to remake the financial culture anew and start changing the music.