We must incentivise long-term investment to help prevent systemic risk

In a letter last month to the Queen of the United Kingdom, Professors Tim Besley and Peter Hennessy, attempted to respond to a recent question by the monarch on how the financial crisis had been able to blow up unchecked with such devastating impact (I’ll let you do your own impression of the Queen talking about markets). The failure, they said was a collective set of “interconnected imbalances” over which no single authority had jurisdiction. These, they said, included a combination of the “psychology of herding and the mantra of financial and policy gurus”, leading to a dangerous recipe where “individual risks may rightly have been viewed as small, but the risk to the system as a whole was vast.” In summary, the professors said: “while it had many causes, (the crisis) was principally a failure of the collective imagination of many bright people, both in this country and internationally, to understand the risks to the system as a whole….” We have no record of whether the Queen came back to ask what was being done to ensure such a devastating crisis could never happen again. The answer might have been: “not much ma’am.” Pension fund beneficiaries have more pertinent reasons than the Queen to demand whether those that “steward” their capital (pension funds/asset managers/insurers) are doing all they can to promote future economic stability. As retirement savers, many of them have seen their pension income decimated by twoyears of depression and will likely be obliged to make greater contributions or work longer. Last week, CalPERS reported assets down to $180.9bn as of June 30, from $237.1bn a year earlier. Californian peer CalSTRS reported assets of $118.8 versus $162.2bn twelve months prior. In June, France’s FRR reserve fund announced that since inception in 2004 it had made annualised total returns of just 1%. The UK has regular astronomic updates on its ‘black hole’ pension fund deficits: £73bn and counting in the country’s top 200 corporate schemes, according to a report by Aon Consulting last week. At the same time, as taxpayers, those same savers have given a colossally expensive kiss of life to a banking and financial system that needed saving from itself. The supposed quid-pro-quo in the form of vital corporate and personal lending has been far from what was promised, according to recent reports in the UK and US, despite rising unemployment, company closures and the potential of crushing future national debt. Investors might have expected strong action to de-risk and remodel the system and iron out the potential for blow-outs that far outstrip the creative destruction inherent in capitalism. To date, they’ve witnessed little other than complex discussions on bank capital adequacy ratios and a worrying recent re-run of business as usual in terms of investment banking bonus wars and a return to outsized profits based to no small degree on a
public intravenous drip combining liquidity, low interest rates and opaque back-stop guarantees. Where are the clear indications that systemic risk is being tackled? Do we yet have legislation to clean up financial accounting and investment product ratings and defuse explosive derivative activity by taking it on to regulated markets and policing it appropriately? At best, relevant rules are on the drawing table marked ‘difficult’. The EU has outlined plans to establish a systemic risk council and the US Treasury is formulating plans, albeit with significant opposition, to formalise the trading of credit-default swaps and other derivatives. Internationally, the G20 has proposed the creation of the Financial Stability Board to provide early warning of macroeconomic and financial risks, but it will have little or no intervention powers. Governments, it appears, don’t have the appetite or leeway to regulate; perhaps for fear of stubbing out the same financial recovery they are praying for. Any unilateral action, they worry, could jeopardise national financial interests. The job of guiding banks and corporates towards sustainable market behaviour – has, de facto, been passed to investors, and in reality to so-called ‘long-term’ institutional investors on the premise that durable economic well-being is the raison d’etre of investing money over decades to pay pensions. The results are a depressing fudge. Institutional investors are reluctant to take up the cudgels, perhaps understandably in the light of government reticence. Take, for example, the recent draft review of UK corporate governance by Sir David Walker, former chairman of Morgan Stanley. While tightening up some common-sense rules on corporate directorships, Walker proposed a beefed-up set of ‘engagement’ principles for institutional investors including a requirement for fund managers to publish their policy on engagement with investee companies under a set of Principles of Stewardship and an obligation to vote shares and disclose. These are all admirable. I think corporate engagement can achieve good results in certain areas and Walker’s proposals will increase transparency and oversight. Institutional investors have so far done little to try and gingerup the findings though. Unfortunately, Walker’s proposals lack teeth and risk becoming nebulous when economic health returns and investors must look to prevent the next crisis, not cast an eye over their shoulder at the last. What will they really achieve in seriously promoting long-term investment? Where is the ‘incentive’ for the ultimate shareholders – the institutional investors – to become owners with their eyes fixed firmly on durable returns and their service providers clearly aligned in this direction also? (nb. fund manager votes against corporate management remain pitifully low). How can pension savers have faith that their savings are being used in their economic interests and not against them? We talk about these conundrums continually without arriving at answers. Paul Myners, the UK Financial Services Secretary and author of the influential 2001 Myners report on institutional investment, this week recognised the problem when he called for Walker to come forward with more “radical solutions”. As an example, he said investors who hold shares for less than six months could be denied the right to vote at banks’ annual general meetings, which he said might give institutional investors more incentive to view themselves as owners of companies, not traders, and become more engaged in the way they are run. As an idea it has its problems, such as creating groups of owners with vested interests that could be short-term as easily as they are long-term, or the issue of differential share pricing. But it is, I believe, a step in the right direction for debate. I would add a proposal for tax breaks or enhanced dividends for long-term shareholders to the discussion mix. There are teething problems with each, but they pale into significance when compared with the market misery of the last two years. In response to Myners’ comments, Lindsay Tomlinson, new chairman of the UK National Association of Pension Funds’ (NAPF) Shareholder Affairs Committee, backed more robust engagement as the solution, adding: “A two-tier shareholder system would not be able to take into account the need for pension funds to buy or sell shares based on external factors, in line with their need to look

after their members’ interests.” How so? If institutional investors are not willing to engage in discussion – warts and all – that could see their special status as long-term stockholders – patient investors underpinning economic activity – recognised and promoted, then perhaps we shouldn’t be surprised to see them become market victims. My fear is that tougher ‘engagement’ could get marginalised again in the maelstrom of recovery as it has done so many times before, especially without enforceable aims.As professors Besley and Hennessy said to the Queen, this market crisis was a failure of the “collective imagination” to understand and right systemic risks. In my view, institutional investors are also showing a lack of imagination as to what their long-term role is and failing to see an opportunity to capitalise on it. Public confidence in pension savings and investments is at an all-time low. The chance to renew and revitalise it may not come again.