Economics

Reforming the capital markets

Without serious reforms, further financial crises remain a real threat

September 02, 2013
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The financial crisis of 2008 demonstrated the way in which poor corporate governance can have grave consequences for the global economy. It made clear to the industry the need for improved regulation of firms and investors. The recent review of equity markets and long-term decision making by the economist John Kay, which was commissioned by Vince Cable, presented an excellent analysis of the shortcomings of investment markets. However, the report failed to put forward policy proposals that would address some of the largest current market failures.

One such problem is excessive “intermediation,” meaning that too many market participants are crowding into the investment process. This causes short-term pressures to increase as brokers and consultants are incentivised to deliver short-term returns. This must be addressed.

A further market failure is information asymmetry—where parties on one side of a transaction have access to more information than the other. For example, fund managers have perfect knowledge of the stewardship work that they conduct promoting good corporate governance practices within the companies within which they invest their clients’ money. However, the clients themselves are limited to relying on reports of selected parts of this stewardship activity, which make it is very hard for them to properly judge performance and demand good practice.

In the UK this has resulted in the publication in July 2010 by the Financial Reporting Council (FRC) of the Stewardship Code for institutional investors. The aims of the Stewardship Code are “to enhance the quality of engagement between institutional shareholders and companies to help improve long-term returns to shareholders and the efficient exercise of governance responsibilities” (p.1)”. They also hope that “by creating a sound basis of engagement [the Code] should create a much needed stronger link between governance and the investment process”

These are laudable aims and this voluntary code is welcome and represents good progress. However, stewardship duties remain underfunded and neglected, in part, due to the free rider problem: one fund manager pays, while all benefit.

Aviva estimates that the average budget of a FTSE 100 company for compliance with the Corporate Governance Code is £5m per annum—the average stewardship budget of the top 100 fund managers as less than 10 per cent of this figure.

There is a dangerous assumption in the Kay review that fund managers will be responsible and that they will accept their public interest role—that they will voluntarily invest more in their stewardship work. This is misguided at best and economically naive at worst. In the absence of informed demand, fund managers will not supply effective stewardship.

Some argue that investor stewardship makes financial sense for fund managers because of the long-term impact on the performance of funds. However, the fund management industry is assessed by performance measures that are too short-term. Much more work needs to be conducted on informing client demand, extending these performance measures, and reducing this information asymmetry. This Code is a good start, but do we really need league tables, certifiable stewardship standards and stewardship duties extended to all those advising or who are responsible for others’ money—including investment consultants?

For too long, investment research has been geared towards short-term trading activity. There is insufficient investment research into stewardship issues such as the long-term sustainability of companies, their strategies, their corporate governance and their business ethics.

Fortunately Kay recognises that the money exists to finance this work. For example, commissions are attached to every trade—despite belonging to the client these commissions are spent by the asset manager. Most equity commissions are split into two parts: execution (for the cost of performing the transaction) and non-execution (for all other services, including investment research). The latter can be used to buy research from any type of provider and the total amount spent is $22bn per year.

This non-execution commission should be channelled towards long-term stewardship research in support of the long-term sustainability of companies, their strategies, their corporate governance and their business ethics.

This would be of enormous benefit to the action to be taken by the fund manager. A few fund managers are doing this. The effect is to add value to investment decisions, which is surely in the long-term interests of clients. However, it is an approach that remains uncommon. It is heartening that the Business Innovation and Skills Select Committee recently accepted this proposal when making recommendations to Government relating to the Kay Review.

The Financial Conduct Authority, the new City regulator, should encourage more responsible investment research to be funded in this way. Furthermore, it should encourage fund managers to be transparent to their clients on the matter of whether they are undertaking such research, what resources are being allocated, how this is being paid for and what it has achieved.

The regulator has the opportunity to use good practice and “nudge” tactics rather than legislation to improve long-term decision making by significantly increasing the scale of stewardship resources in the investment market. This would fundamentally transform long term investment analysis and investor stewardship. Without serious proposals to reform the system as a whole, further financial crises remain a real threat.