Charles Mackay’s 1841 classic book: ‘Extraordinary Popular Delusions and the Madness of Crowds’, has been a staple for readers – notably financiers – interested in some of the biggest – and strangest – societal neuroses in recent centuries. Alongside a fascinating chapter on the ‘Influence of politics and religion on the hair and beard’ (bear with me), there are accounts of the wildest and most damaging historical financial speculations: Tulipomania in 17th century Holland, the South Sea bubble in 18th century England and the Mississippi Scheme of 1720 in which Scots rogue, John Law, bankrupted the French state and many of its citizens with promises of riches in the Americas. The book records the seemingly inexorable link between greed, folly and herd mentality; all present and correct in our latest financial breakdown to such devastating affect. Re-reading Mackay got me thinking about the practical, tangible responses of regulators and institutional investors to the credit crunch to try and ensure it doesn’t happen again. Amidst the political and public clamour for resolution, I wondered if there had actually been any action yet, outside of short-term banker bonus hysteria? Are we doomed to relive the same calamitous bubble manias over and over again, and can we afford to? The answer to the last question should, I hope, be no, with the caveat that financial bubbles are probably unavoidable. Systemic blowouts, however, almost certainly are, if the right combination of monetary policy, regulation and sustainable ownership of assets isapplied. Where institutional investors manage public money the avoidance of systemic breakdown should arguably be hardwired into their investment DNA. Savers cannot be penalised twice: both as backstop bailout taxpayers and victims of market catastrophes that destroy the value of their pensions and investments. The lack of action got me wondering whether our current governments, regulators and institutional investors might not be pray to an extraordinary delusion? Paul Myners, UK Financial Services Secretary and former chief executive of Gartmore, the UK fund manager, certainly appears to think institutional investors are. Apologies for a UK-based analogy, but I think it demonstrates a broader point. In a speech last month to the UK All Party Parliamentary Group on Corporate Governance, Myners didn’t mince his words: “To date, institutional investors have said little about the lessons they have learnt over the last two years. Put simply, they have not produced satisfactory answers to the question: ‘what were the owners of these banks doing?’ Remember that shareholders approved value-destroying transactions, and remuneration practices that now appear to have been poorly aligned with corporate health and shareholder wealth. I expect institutional investors, on behalf of their clients, to be much more challenging in the future than they have in the past, but I wonder whether their clients have similar increased expectation and have reflected this in their manager dispositions and incentives.” Tough words, which Myners intimated would be followed
by action: “There will be more regulation. And there will be tighter supervision. And both will need to be linked to stronger organisational governance and effectiveness. We can use regulation to make governance better, but it is incumbent on investors and their agents to be the drivers of change.” Yet Myners’ last point was key. Since he made the speech, the UK Walker report on governance of banks and financial institutions was released. In my view, the report – looked at by investors worldwide as a potential template for better corporate oversight – does relatively little to tighten up the rules, outside of bonuses paid in shares over longer timeframes. Walker, like Myners, favours further exhortations of investor activism as the ‘drivers of change’. The actions, rather than the words of both Myners and Walker, look sorely like a ‘realpolitik’ regulatory cop-out. Politicians tend not to regulate financial institutions too heavily on the domestic front these days for fear they will decamp to lighter regulatory regimes, taking their tax revenue with them. Government financial policy is decided within the G8 or G20 country meetings or the current International Monetary Fund discussions on banking reform; all fraught with the potential for beggar-thy-neighbour regulatory arbitrage. If governments are loathe to legislate forcefully on governance to prevent future crises, can investors really be expected to take up the slack? Shouldn’t they instead be pushing Myners, for example (or their relevant domestic regulator) to legislate meaningfully while in a position to do so? Are they? Unfortunately, I see little evidence they are. Some institutional asset owners I talk to, think Myners is suffering an extraordinary delusion of his own about what they can achieve in terms of shareholder ownership. Many pension funds are relatively small organisations and have a trustee/investment board that meets just a few times a year: hardly a strong platform for change. They are also rebuilding tattered balance sheets and keen to see share prices rebound and things get back to’normal’ – even if the current stock market rebound appears to reflect the global effects of government intervention through quantitative easing than a return to economic health. Many feel – or purport to feel – a
sense of inertia about their ability to influence the market. They tend to support good governance and will prod their asset managers to vote their shares, but second-guessing company management is not at the top of their ‘to-do’ list. That may be short sighted, but most asset owners are hardly set up to do much more. Larger schemes tend to be more active on ownership, but they don’t make up the rump of the pensions sector.
“The actions, rather than the words of both Myners and Walker, look sorely like a ‘realpolitik’ regulatory cop-out.”
Fund managers – the ire of much of Myners’ criticism – are unlikely to rock the governance boat until given clear signals by their clients. This leaves us with a classic Catch 22. That said, I believe the thrust of Myners’ questioning is valid. And in his defence, Myners has been one of the very few influential figures to relentlessly bang the ownership drum – recognising its importance. Why do asset owners – the pension funds, insurance companies and sovereign wealth investors that are the principals in the institutional capital chain – appear reluctant to act together in their own interests and conduct their own crisis post-mortem? Surely it is part of their fiduciary duty to beneficiaries to do so; not to say of utmost importance to their quest for more robust future financial returns? Where is the research/intervention, for example, on structural market problems such as off-balance-sheet banking vehicles, excessive leverage limits, the long-term value of M&A deals, the inherent danger of credit default swaps, clarity in the audit
process, the rating of financial instruments, or the introduction of a Glass-Steagall equivalent to split retail and investment banking; all of which were part of the toxic chain that brought the system to meltdown. I have seen little, as if ignoring such issues might make them go away. Where also is the examination from pension funds on current bank lending, or lack of, to small and medium-sized businesses, or the spectre of rising unemployment, both of which are anathema to healthy economies and investment returns? There is, it seems, a kind of collective neurosis that binds regulatory impotence and investor inertia. It reminds me of the impasse over long-term investment mandates. Many in the investment world believe they are vital to promote better governance and sustainable corporate ownership. Yet after decades of debate we are no nearer to seeing them because investors will not – perhaps understandably – relinquish the right to sack underperforming fund managers. Could some of the ingredients for a remedy to this institutional mental block be under our collective noses though? A recent survey we co-produced at Responsible-Investor.com, in tandem with the Network for Sustainable Financial Markets (NSFM), an international on-line network of senior financial market professionals and academics, and AQ Research the investment research and data group, threw up some fascinating responses.
Critically, the survey titled: “Credit Crisis: Business as usual for institutional investors?” was answered under guarantee of anonymity by 208 investment professionals. Half of these were from mainstream asset management firms, while 32.6% responded from sustainable investment specialists. The results were evaluated for bias between the views of mainstream and sustainability-driven managers, but there was no discernible difference. Tellingly, more than 90% of these institutional investors believed financial
markets were now threatened by increased ‘moral hazard’ – the belief that banks and other investors will takeexcessive risks based on implicit government guarantees – following the credit crisis bailouts than they did before it, and that fixing this must be a priority to ensure the sustainable functioning of markets. Just under a third of these same investors (28%) were pessimistic that the right lessons from the crisis had been learnt to avoid future market blowouts. And 80.5% said the response of regulators had so far fallen short of what is needed to fix the system. The results suggest that while we see very little group action from investors, many financial market participants are privately very concerned about our collective response, or lack of, to the credit crunch and its future financial and social implications. In public, relatively few are willing to speak out against the group or the prevailing market orthodoxy. The results tally with the thrust of a 2004 book by James Surowiecki, titled: The wisdom of crowds: why the many are smarter than the few and how collective wisdom shapes business, economies, societies and nations”, written as something of a response to Mackay’s 1841 book. Surowiecki argues that aggregated information from groups leads to decisions that are better than could have been made by any single member of the group. The opening anecdote of the book relates the tale of a crowd at a county fair that accurately assesses the weight of an ox when their individual guesses were averaged, beating the estimates of individuals and experts alike. Most people realise there is no magic bullet reform that would prevent future crises, and that managing the last crisis is unlikely to prevent the next. What is needed therefore is active forward thinking on the regulatory and governance fronts. Might one solution then be to harness this wisdom of crowds? Such an institutionalized ‘anonymous’ and regular investor survey could represent a neutral starting point for regulatory discussion and act as a vital bellwether for the prevention of future financial catastrophes.
Link to the report: Credit Crisis, Business as Usual for Institutional Investors?