Memorandum from David Pitt-Watson, Hermes
Equity Ownership Service
Some issues for the Committee to consider.
BACKGROUND
In general, capital markets have served us well.
The continuing growth in the world economy, despite commodity
price shocks, is a tribute to their efficacy.
Hermes is a significant fund manger, managing
and advising around £80 billion, on behalf of pension fund
clients. Hermes itself is owned by the BT Pension Scheme. It is
well known for its "stewardship" programmes; that is
trying to behave as an "owner" of its clients interests,
not just a trader of securities. In investment terms we are equally
concerned with generating "beta" (absolute market performance)
not just alpha (out performance, irrespective of market movements).
David Pitt-Watson, is a co-founder of the stewardship
activities at Hermes, and Chair of its Equity Ownership Service.
He is the author of The New Capitalists, a book which describes
how capital markets can be made more accountable and responsible.
While recognising the benefit of trading securities,
the lack of focus on ownership has contributed strongly to the
credit problem.
WHAT HAS
HAPPENED
The Credit Crisis
In the past, if a bank made a loan, it held
it on its balance sheet. It owned the loan, and was therefore
concerned that its customers were fully credit worthy. However,
the capital requirement, and therefore the cost of a bank holding
a loan, was higher than if it were held in a special purpose vehicle,
off the banks' balance sheet. To take advantage of this, many
loans are made (originated) by individuals, banks and others,
then packaged up and sold on to "the market". This process
is known as disintermediation. Disintermediation has meant that
banks had less need to check credit worthiness. Incentives were
simply to write more loans, take a fee, and sell the loan, or
parts of the loan on to others. This created a perverse incentive
of the type which is common in financial services.
In order to be assured that loans were creditworthy,
the market therefore depended on rating agencies. These are a
regulated oligopoly, paid by the issuer of the loan, and therefore
cannot avoid concern about conflict of interest. They often sell
other services to companies whose bonds they rate.
Further, accounting standards have increasingly
adopted the "fair value" rule, to valuing securities
on the balance sheet. Old principles of prudence can often be
sacrificed by adherence to such rules, especially where there
is no market for the securities in question. This then can temporarily
flatter profits and balance sheets.
Holders of these credits behaved as traders.
Provided they felt they could "read the market", and
sell on the security, they paid less attention to its fundamental
value, (indeed after disintermediation, and possible splitting
of packaged loans into their constituent derivatives, it would
be difficult for them to have done so). This is just the way Keynes
described the way that stock markets worked. Traders seek alpha,
with little concern for beta, even though it is the beta which
will ultimately pay our pensions, and alpha is, at best, a zero
sum game.
The fallout from these practices, particularly in
the USA, has still fully to be understood.
Northern Rock
Prior to its collapse, Hermes, as part of its
stewardship programme, had made contact with Northern Rock, to
raise questions about its business model, its remuneration and
accounting disclosure. Clearly it could have been more probing
and forceful. However, Hermes represented just over 1% of NR's
shares. The Select Committee will doubtless be inquiring what
other shareholders did, what the board did, and what the auditor
did, to question the very aggressive strategy the bank was following.
As a result of NR's collapse, pensioners and
other owners of NR's shares have now lost £4,000 million,
about £150 per household in the UK.
Perverse incentives may also have been at work
at Northern Rock. The effective guarantee which the government
gives to banks would be expected to encourage imprudent money
market lending, particularly if it is secured in priority to retail
depositors. In addition, banking regulation encouraged the creation
of off balance sheet vehicles, such as Granite.
The tripartite system failed, in the sense that
the Bank of England had to U turn. Having said that, one must
have some sympathy for the need to avoid moral hazard, and the
UK regulatory regime is held in high regard.
WHERE MIGHT
SOLUTIONS LIE
These problems will not be solved by regulation
alone, but in combination with a greater focus on ownership responsibility,
and transparency.
Certainly there could be value in reviewing
banking regulation, and accounting in relationship to off-balance
sheet finance.
One could suggest tighter standards for Credit
Rating Agencies, (CRA's), to ensure their independence. The
official US oligopoly on CRA's could be reviewed, especially
if they cannot show how they are independent. There could be
a review of whether it is appropriate that they sell other products,
and if they do, what transparency is appropriate. Investors could
initiate and lead this, (and be held accountable for their conclusions).
We could slow the dash to IFRS, and its
focus on fair value. A challenge could be made to adoption
of market based valuations. Investors could be better represented
throughout the IASB structures, which is responsible for the
standards adopted.
We could review the role of investors as
owners. Lots of progress has been made here, but much remains
to be done. Principally it's pension funds and their like that
lose in financial crises, yet few do much to ensure good stewardship,
to oversee, or get someone else to oversee accounting and other
regulation. What, for example, does the House of Commons scheme
do in this regard? We could ask all public sector schemes to
ensure best practice in ownership.
We could review bank liquidation procedures.
We could review the tripartite system,
in particular ensuring the FSA monitors all aspects of banking
risk, and is fully appraised of how the Bank of England intends
to respond to any failure. The FSA and the board of any bank,
particularly its non executives could be in closer conversation
about risk.
The committee also raised questions about the
role of hedge funds. Certainly some of the funds which are described
in this way are quite opaque in their investment. Again, it might
be helpful if long term investors could ensure that the activities
of hedge funds and other vehicles in which they invest are transparent,
and do no damage the capital markets upon which all investors
depend.
Few of these will be achieved by law and regulation,
which are likely to be cumbersome, and have unintended consequences.
It needs a new mood of responsibility in the capital markets and
the fund management industry, which should be led by the individual
savers and their fiduciaries, It is their pensions and savings
the industry should be seeking to secure.
December 2004
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