Select Committee on Treasury Written Evidence


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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