Oral Evidence

Taken before the Treasury Committee

on Tuesday 22 May 2012

Members present:

Mr Andrew Tyrie MP (Chair)

Mark Garnier

Andrea Leadsom

Mr Andrew Love

Mr Pat McFadden

Mr George Mudie

Jesse Norman

Teresa Pearce

Mr David Ruffley

John Thurso


Examination of Witnesses

Witnesses: Baroness Hogg, Chairman, Financial Reporting Council, Peter Montagnon, Senior Investment Advisor, Financial Reporting Council and Sir David Walker, Senior Advisor of Morgan Stanley gave evidence.

Q1 Chair: Let’s begin. Can I begin with you, Sir David, and ask whether you think that what is now universally acknowledged to be the special nature of systemically risky institutions implies the need for a special form of corporate governance?

Sir David Walker: Yes. The only hesitation in my voice is that I do think there is need as well for enhancement in the quality of corporate governance in all corporates, which is not generally working anything like as well as it should. But I agree that there should be particular emphasis on financial institutions and, within them, on banks in particular.

Q2 Chair: How should that be delivered, in a nutshell? You have done a lot of work on this.

Sir David Walker: I think the one critical thing, of all the other things that need to be done, is for the board, in recognition of its responsibility for the risk of the entity-which previously was inadequately recognised in many cases-to have a board-level risk committee that is dedicated to determining the risk appetite of the entity and ensuring that the risk taken by the entity stays within that appetite all the time.

Chair: It certainly didn’t seem to have happened at RBS.

Sir David Walker: Nor, apparently, in other cases subsequently.

Chair: Is there anything you want to add to that, Mr Montagnon?

Peter Montagnon: Well, I think that there are, in banks, special circumstances because of the systemic risk and because of a need to protect consumers and that means the balance between governance and regulation is bound to be slightly different, but it doesn’t mean that some of the sort of core principles of governance, which are the ability of boards to make good decisions or robust decisions and the ability of boards to manage risk and be accountable to the providers of capital, don’t apply in banks. It means that the balance is slightly different. There is an overlap here and we have to make sure that we get the benefit of good regulation and governance in banks and that is quite a challenge.

Q3 Chair: On the basis of what we have seen since the crash began, Baroness Hogg, do we think that what we see developing in the PRA and also in the FCA, in the way that they’re developing the collection of information with respect to corporate governance, should give us confidence that we’re on the right track on all fronts?

Baroness Hogg: This is going to get us deep into the alphabet soup very early on in the morning, I realise, but if I may talk from the perspective of the FRC, the Financial Reporting Council, whose core responsibility the Corporate Governance Code is. We have set in place quasi-formal mechanisms to work with the shadow PRA and FCA to ensure that we don’t all trip over each other in the corporate governance arena. We agree very strongly with Sir David that it is appropriate to have a different regime for systemically important financial institutions. When we revised the Corporate Governance Code, however, we both reemphasised the board’s role with respect to risk, as Peter has mentioned, and also came to an agreement with the FSA that those aspects of Sir David’s report that we thought to be specific to systemic institutions should be, as it were, monitored and enforced by the FSA, and now the PRA, and should not be put in as a kind of sub-code within the Corporate Governance Code applying to all companies.

So, for example, this emphasis on risk management in the Corporate Governance Code emphasises very much the role of the board, because I think corporate governance over the preceding five or six years had rather allowed that risk role to drift out to the Audit Committee. That was very clear in the American model, for example, where Sarbanes-Oxley took that risk management piece right out to the Audit Committee and we wanted to put it back and emphasise the board’s responsibility here. We would also leave to boards across the whole spectre of corporate Britain how they structured their committees so they didn’t necessarily have a single risk committee. They might, for example, identify an aspect of risk that in some industries would be outstandingly important, health and safety for example, and have a special committee for that, rather than have too much of a cookie-cutter approach to the entirety of corporate Britain and its committee structure.

With respect to the FCA I think there is going to be some shaking down between the two halves of the old FSA as to what their role in corporate governance is, and it is important-and it is why we think our semi-formal arrangements are important-that it doesn’t become too competitive, because that will end up being perhaps excessively intrusive or leave boards in a state of confusion as to where their responsibilities lie.

Chair: Sorry to interrupt, but you mean competition between the public bodies chasing information?

Baroness Hogg: Rather less chasing information, because information ought to flow freely, but being competitive in terms of who took the lead with the governance of a particular institution. So, I think it will take a little bit of shaking down between the PRA and the FCA.

Chair: That sounds very polite, Baroness Hogg.

Baroness Hogg: Absolutely.

Q4 Chair: No more than I would expect, but are you saying basically that they are on the right track, that the kinds of information that they are now demanding and the approach being taken are broadly correct?

Baroness Hogg: I think information should always flow freely. I think regulators have to be careful, as Sir David has said, that they don’t get in the way of accountability to shareholders, because otherwise, an important discipline is lost and ultimately, potentially, access to capital may be impeded.

Q5 Jesse Norman: Mr Montagnon, FTSE 100 company CEO pay-how much has that gone up over the last decade?

Peter Montagnon: I couldn’t tell you precisely. In any case, I think it is really quite difficult to calculate. You would see different figures, but it is quite clear that it has gone up much faster than everybody else’s pay and I think that is an issue for the shareholders and possibly for the public more broadly.

Q6 Jesse Norman: Yes. It is about 400% over the last 12 years and take-home pay has gone to about 88 times that of a full-time UK employee. Do you think the efficient market theory is working in terms of compensation?

Peter Montagnon: Not necessarily. I think one of the issues here is that obviously the shareholders have some rights on remuneration. Their interest is primarily in successful companies and they want to see the remuneration calibrated to the delivery of that success. As shareholders, they are not necessarily equipped to know what the going rate in any one industry is. They are not HR people and so there is something of a disconnect there. I think it is probably fair to say that the system has not been working particularly well, but we know that the Government is actually addressing this and is going to bring in measures that may make a difference.

It is also worth noting that recently, as this issue has become more exposed, the shareholders have become much tougher in pushing back on excess. So we are on a journey from somewhere that hasn’t been very good, to hopefully somewhere better.

Q7 Jesse Norman: Thank you. How many reputable studies have found a significant correlation between executive pay and long-term corporate performance?

Peter Montagnon: I am not aware of many that have.

Q8 Jesse Norman: I don’t think there are in fact any, for what it is worth. We are short of time. Baroness Hogg, given that the systemically important institutions are as large as they are in most cases and are as entrenched as they are and do not have the same competitive pressure experienced elsewhere in different markets, is that not a further argument for tougher governance arrangements?

Baroness Hogg: I think we could debate the competitive issue longer than this Committee has, so I won’t be-

Jesse Norman: Not for very long, given what we have seen in the market.

Baroness Hogg: Exactly. I won’t go down that route, but I think-

Q9 Jesse Norman: You are not suggesting these are competitive markets, are you, when we have four banks essentially controlling vast amounts of the mortgage market, the retail deposit market and so on?

Baroness Hogg: I think aspects of their activities are competitive.

Jesse Norman: Good. No one is denying that, but in general they aren’t very competitive.

Baroness Hogg: What I would like to get to is the point that the rationale for a more, if you like, regulatory rather than soft-law regime for systemic financial institutions is precisely because they are systemic. If something goes wrong in a non-systemic company the shareholders lose their money. As self-evidently we have seen, if something goes wrong in a systemic institution the taxpayer has to pay. So it is axiomatic that there has to be much heavier regulation.

Q10 Jesse Norman: Your argument is it should be a tougher regime, but it should be more focused on regulation and less on, as it were, governance?

Baroness Hogg: No, I think there should be both. I think you should maintain the Corporate Governance Code. I wouldn’t like to see it swept aside because shareholder pressure can be very important in these institutions, too, as we have seen reasonably recently. I think if regulation drives corporate governance and accountability to shareholders out the door, that is quite dangerous too. The regulator is putting itself in quite an uncomfortable position of, as it were, having usurped shareholder rights and we have to be careful about that.

Q11 Jesse Norman: Thank you. Sir David, a final question. It has been observed that no rational person would go on to the board of a public company, let alone a bank, under present circumstances. Do you think the effect of that is to deter high-quality people and, therefore, to reduce the overall quality of directors from these institutions?

Sir David Walker: Two observations, Mr Norman. One, it is for the reason that you suggest that I would argue against the idea that has been canvassed by some that the responsibilities of directors, on major financial institutions at least, should extend to strict liability. I think that would drive people away. I am not a lawyer, but how all that would operate in the courts-the only thing that would be certain would be a mountain of litigation. But as to whether good people are less ready to serve on bank boards, I am glad to say I haven’t observed a drying up of supply, and I think there is a demand pull along the lines that the substance of the responsibility of the non-executive director on one of these very complicated, hugely significant boards is a challenge that some people are very ready to rise to. So I think the news is quite good on that front.

There is one other observation I would make, which is relevant to that. I am asked all the time, "What do you think? Do you have an opinion", and so on, on people for jobs and job specifications. I think the head-hunter process, combined with what the FSA are now doing, which is examining people before they go forward to being board members of these major entities, is much more rigorous. For example, the head hunters are doing, I can’t say in every case, a much tougher job specification at the beginning of the process, which I think was not-

Jesse Norman: It had been rather sloppy beforehand.

Sir David Walker: It was very sloppy.

Jesse Norman: That is helpful. Thank you.

Q12 Chair: You are reporting to us that, though it is irrational for these people to take these risks by going on to boards, they are acting irrationally just like the markets?

Sir David Walker: Leave aside, Chairman, if I may say, markets; I don’t agree. This view of rationality is not one that I share.

Chair: So you are disagreeing with the principle.

Sir David Walker: Yes.

Q13 John Thurso: Can I just start by following up Jesse Norman’s question with Mr Montagnon. Is there a direct correlation between the creation of remuneration committees and the ever-increasing upward ratcheting of pay?

Peter Montagnon: Between the remuneration committees and the ratchet I think probably not direct, but I think there is an issue that people look over their shoulders at what other people are getting and they would like to get more, and so you get a ratchet through that process. I think in that area the remuneration consultants who make a living out of advising people do contribute to the ratchet. I think it is the remuneration consultants, probably, rather than the committees.

Q14 John Thurso: I just observe that the first plc board I sat on was pre-Remcos and the chairman always told us we couldn’t have any more money, and every board I have sat on and every Remco I have been on ever since, everybody has said, "How do we justify getting higher up so we make sure we’re in the top quartile?" Is it not self-evident that, therefore, they will always ratchet?

Peter Montagnon: Well, that may be remuneration committees-it may just be the way the boards’ views of things have changed. Time moves on, but I think remuneration consultants are quite an important part of the ratchet.

Q15 John Thurso: Sir, David, can I come to you? You were co-author of the G30 report Toward Effective Governance of Financial Institutions and that report, quite properly in my view, laid considerable emphasis on values and culture in financial institution governance. Many financial institutions state as one of their first aims the return on capital that they will aim for. To what extent does return on capital stated then guide the values and culture and the governance?

Sir David Walker: I think it is deficient. My view is that there are things, in a way, that we don’t need to talk about. There needs to be integrity and honesty and all those things, which are motherhood and apple pie propositions-hugely important if ever they are defective or absent. But the thing that return on equity or return on capital, these conventional measures of return, very rarely capture is-if I could use the word that I think is critical in this and the most important value that I think is neglected-sustainability.

One of the great problems we have in financial institutions, I think in corporate life generally, is this creeping myopia. I think, therefore, that one of the values I would be very attentive to as a chairman or as a board member is: is what we are seeking to do sustainable? This would be very high up on my list of values. That ticks a huge number of boxes because if we’re doing something that is not right, it is not going to be sustainable and if we are getting a quick buck as a result of something we are doing now, that won’t be sustainable.

So, I would have as a value, very prominently on the list, sustainability in everything we do and I think if that is driven by board decision right down the organisation through the executive, you then have a culture that has sustainability in it, but it applies to everything. I mean the regard of the corporate for the environment, which I know is not what we are talking about today-but in all other aspects of corporate life.

Q16 John Thurso: The reason I ask is that I think one of the major banks recently said its goal was 15% return on equity. Allowing for inflation at around 2%, that is a real return of around 12% to 13%. A prudent utility bank is looking to a very high reward at that level for its operations, which tells me that built into its return on equity is an automatic culture of taking risk. Do you think that is in fact the case?

Sir David Walker: I think, on the whole, not. Of course, all these banks are very concerned. Chief executives are concerned to satisfy their shareholders that they are an attractive place to invest, in particular in circumstances in which they may want to raise more capital. I make two substantive observations. One is that the hardware of financial services, and in particular banks in terms of a black letter regulation, is now hugely tougher than it was before 2007. As the FSA reports and all the rest have made clear, regulation in relation to capital, the ratios, the definition of capital, leverage and liquidity was palpably inadequate and that is now moving into, let’s say, the position where it ought to be. You can argue about the margin, but that is now very much better.

If I could, as my second observation, go back to something Mr Norman was talking about. I think one of the reasons in the utility space-let’s leave aside the high-risk investment and other banking-that margins persist in being so high is the absence of competition. I should declare an interest. I have an interest, which is in the public domain, to acquire the assets, with others, that are being disposed of by Lloyds Bank and the view we, those of us who are promoting that proposition, have is that the margins are fat in retail banking and that we can earn a very good return for our shareholders in sharp competition with the incumbents.

Q17 John Thurso: I am becoming increasingly aware of how much the products sold by straightforward utility banks have come from, particularly with regard to businesses, their capital market’s arms, which may be wholly inappropriate to the actual needs of the business. One estimate is that the misselling of swaps is currently costing the country some £100 billion to £120 billion. I saw an internal email recently from one of our big four banks, where the manager said, "How do you think the client feels to have his arms and legs ripped off?" Now that, to me, is a despicable culture that is doing immense damage to United Kingdom commerce and comes from the decision at the top to go for an unrealistic return on equity for providing what should be a basic utility for business to grow. Could you comment on that?

Sir David Walker: Yes. Two comments-I basically agree with you. I think there have been two major failures. One, the regulator should never have allowed access to the retail market for these complicated products, and that goes much wider than the swap products you are describing now. I said at the time, and the FSA have said it publicly, I was very hesitant about whether the FSA should ever have allowed access to hedge funds-another area-for the retail customer and the threshold has been lowered. Of course, the reason for it, Mr Thurso, was, why should a member of the general public not have access to these instruments, some of which are very high performing? Why should they be denied access to these potentially very rewarding instruments? Well, we know the story in many cases and it is very unsatisfactory.

Q18 John Thurso: If I may, the point I am making is that a number of companies said, "We don’t want this. They don’t make sense", and they became "must have". You cannot have your facility for five years unless you take a 20-year swap.

Sir David Walker: Well, that joint product approach should have been blocked. It was a regulatory failure.

John Thurso: It was nearly immoral, close to it.

Sir David Walker: Leave aside the normative judgment, it was-

Baroness Hogg: Certainly anti-competitive.

Sir David Walker: Anti-competitive and a mistake. The second observation I make, which is closely aligned with your judgment, is I think what boards allowed to happen was-business units who were eager to distribute these new products on which the margins were fat and where the senior management were persuaded, "We are providing something that meets the needs of our customers", at least customer-friendly. I think senior management or leadership were taken in by that and should have had a firmer line. I hope from now on, in the light of the experience of PPI and this swap stuff and so on, we will have much less-

Q19 John Thurso: Last quick question, if I may. How do we get that value of fairness, sustainability and honesty to all stakeholders at the heart of a financial institution board?

Sir David Walker: If I may say, I just think we have to go on talking about it in forums such as this, and this Committee and the regulators need to place greater emphasis on it. You didn’t mention, Mr Thurso, a more, in my view, deeper-seated taint of the whole process, which I think has done massive damage in the insurance industry, which is the commission system. The payment of commission-where you pay a larger commission the less the quality of the product, to ensure that you get it off your shelf-has been basically a corruption of the whole life assurance/pension phase of the last 25 years. That is why the retail distribution review of the FSA that is now being promulgated is, I think, overdue but very welcome.

Q20 Andrea Leadsom: Yes, it falls to me, as one of the only two women on the Treasury Select Committee, to raise the issue of women on boards of financial services companies. Is this a trivial matter? Does it matter that there are so few women on boards of banks and other financial services companies and is it important that there are new guidelines around achieving 25% of women on boards? Does that matter to you, Sir David?

Sir David Walker: Yes, I think it is very important and it is unsatisfactory that women are not better represented on these boards. I would make two observations. First, I think it would be very unfortunate for women if they were put on boards to fulfil a quota obligation. I think that demeans the women who have these posts by virtue of their capability and excellence and all the rest.

The other observation I would make is I do think progress is now being made. There are a lot of things that can be done and I hope are now being done. I am hugely supportive, I may say, of Lord Davis’ report and I think among the things that I see as very practical measures to get there in three or four years’ time is, for example, to have every chief executive of a FTSE company see it as part of his responsibility to identify a woman in his organisation, who may or may not be suitable to sit on his own board as an executive director, to help mentor and encourage and promote her to sit on someone else’s board. I think that can only happen, first, if chief executives do that-and I have talked to a lot of them about it and I know some of them are actively on the case-and, secondly, if the ladies themselves and the chairmen of the boards to which they go are ready to take some risk. I think it has to be understood it won’t always work perfectly, but let’s try.

Q21 Andrea Leadsom: That is very interesting. Baroness Hogg, I am interested in your view. In my opinion we made a massive mistake in letting Margaret Cole go from the FSA without giving her a real shot at the head of the FCA post. I am sure you won’t want to comment on that and nor should you, but that is my personal opinion. But isn’t that symptomatic of the fact that all-male boards are extremely male-and, as you have just so expressly said yourself, Sir David, "A chief executive, he should decide. He should find a woman and then promote her", because clearly she won’t be competent until he does such a thing? Isn’t that part of the problem-that all-male boards think that that is absolutely fine and the norm, and that there aren’t women just there who are good enough to do it? Why is it that women are outperforming in school, they are outperforming in university, and then they fail further up the ladder? Having had 25 years in financial service, I have some very strong views about this. I certainly remember being told when I had a child or wanted to work part-time for a period of time, "We’ve managed without female senior executives until now and we certainly don’t need part-time ones". That was the attitude of the male managing director. I think that there are fundamental problems that are causing women to have this inability to progress. Baroness Hogg, what do you think?

Baroness Hogg: Well, indeed it is a non-trivial issue and I think the mix around the board table is extremely important. In the 2010 version of the Corporate Governance Code we added language that said, "Board appointments should be made on merit against objective criteria and with due regard to the benefits of diversity around the board table, including gender diversity". That was the first marker reference in the Code. The Code, following the Davis Report that comes into force this autumn, will require-in Code terms, because there is always a complier explaining Code terms-companies to explain what their policies are in this respect and to articulate any measurable objectives. We believe those are very important stimuli to change. This is for all companies, not just financial institutions.

There was a bit of an issue, I think, following the financial crisis when the FSA, as has been described, stepped up its approval process to be a rather more vigorous filter of proposed appointments. Word got around that women were not making it through the filter because there was a kind of swing back to expertise and, your good self excepted, there weren’t that many women with lifetime careers at a senior level in financial services that were prepared to take on these appointments. I am glad to say that the FSA has found its way through that point so that there are appointments being approved that have given the lie to that assumption, but I think it was a danger point that could have sent things swinging back the other way.

I very much agree with what Sir David says about the mentoring process, only I would put it at the chairman level. It was established at a time when I was still the chairman of a FTSE 100 company that chairmen of FTSE 100 companies each put forward a senior woman within their organisation for mentoring by another chairman, and this helped to achieve breakthrough with respect to nomination committees in particular. It was all men, you are quite right, apart from me, but that is changing slowly too. We are seeing changes in the rate of appointment, and I hope that the requirement to articulate a policy will be helpful in the very Code-based form that we have developed-that requiring people to explain creates a stimulus to action, in a way that quotas create resentment. So we hope this will prove a vigorous way forward within the UK.

Q22 Andrea Leadsom: Thank you. Mr Montagnon, very quickly, do you think there is any merit, other than simple equality, in having more women on boards? For example, the Women on Boards paper of February 2011 suggested that women bring different qualities to a board. Certainly in this Committee we have had hearings with Ana Botín and Jayne Anne Gadhia alongside some of their male counterparts, and I certainly enjoyed their slightly more mea culpa attitude compared to the very aggressive, "Not our fault, don’t blame us, just keep paying us" attitude of some of the men. Do you think there’s any merit in having women for their qualities, or is it just a matter of diversity and equality? I can see I am really upsetting everyone here now.

Peter Montagnon: The answer is, yes, there is merit in having people for their qualities and women may bring different qualities. I think it is quite a dangerous stereotyping here. What you need is the right people, male and female, female and male, to make the board effective. I think diversity is very important and I think we shouldn’t see this just as a numbers game and balancing the numbers. What we have tried to do in the FRC and with the Code is anchor this in a really strong belief that diverse boards are more likely to be effective than boards that are lacking in diversity, and boards that actually don’t have gender diversity are unlikely to be sufficiently diverse to fulfil that effectiveness criteria. So the answer is, yes, it is very important to have people with different qualities on boards, whoever they are.

Baroness Hogg: May I, Chairman, just add, we cited three points in reference to the Code. One was, exactly as Peter says, helping to avoid group-think. The other was aspirational within a company: if women within the company look up and see no one of their gender at the top, that may affect aspirations; and third, for many companies a sense of engagement with customers. We have always stuck on those three and not been dragged down the enticement of complicated pieces of work that turn into established correlations for performance, because I think that is quite dangerous territory.

Chair: All three of our witnesses want to pile in on this one and I wonder why. Sir David.

Sir David Walker: Just very briefly to say that one way of characterising corporate governance in financial institutions before the crisis, but probably many others as well, is that certainly in this country-but I believe elsewhere and particularly in the United States-they were far too collegial. So the word I have been very keen to deploy and promote, greatly irritating some, is "challenge". Diversity is likely to provoke, invite, elicit challenge, and women are part of that.

Q23 Chair: But you are not suggesting women are less collegial, are you, Sir David?

Sir David Walker: Well, I was talking about diversity, Mr Chairman. I think a board is more likely to be collegial if there is not much diversity. If there is diversity you have an atmosphere that is readier to contemplate challenge and take different views and women are part of that.

Chair: This whole area is fraught with personal traps, don’t you think?

Q24 Teresa Pearce: It is really hard not to comment on that last one. I will leave it where it is. Just following on from my colleague John Thurso’s conversation mainly with Sir David, talking about risk and remuneration and sanctions for senior executives. I would be interested, Baroness Hogg, in your response. When the Financial Services Authority published its report on the failure of RBS they suggested there may be a case for introducing strict legal liabilities for executives or changes in executive remuneration, and they said "to strike a different balance between risk and return". Do you agree with that? If you do, what do you think are the merits or the drawbacks of those proposals?

Baroness Hogg: On the legal liability point, I am inclined to agree with Sir David that the warning that, in the Chairman’s words, you would have to be totally insane to go on the board of any company, let alone a financial institution, might lead to a dearth of candidates. I think there is a danger if you go down that route that you would, let’s say, make the pool rather shallower.

In terms of remuneration there is a lot of thinking going on now, which I think is leading to important changes from a number of directions. We have the BIS consultation. We have the "shareholder spring". Before that we had, and I would say it plays a part in both, the change in the Corporate Governance Code that gave shareholders the chance, through annual election of directors, to make their views felt on any member of the board at each AGM. I think that is an interesting example of how shareholder power has changed. It is only just coming into force, which is why I think we’re only beginning to see the dynamics from it, because when an annual election was introduced there was quite a lot of noise from the corporates. They didn’t like it much.

Shareholders had, on the whole, been in favour of it and corporates, on the whole, against. But it shows the respect, I suppose, in which the Code is held that within a year over 80% of the FTSE 350 had moved to annual election. As shareholders have become more concerned about remuneration, they therefore have the mechanism to make their views felt in a way that can feel pretty personal to members of the board, and that is pretty powerful. Do you need liability as well? Well, it might be going a step too far in terms of discouraging candidates, but annual election creates a new power pressure on members of the board concerned with either setting or receiving remuneration.

Q25 Teresa Pearce: Do you not think that the general public, where they see such huge reward, think there should be huge risk as well? If it is your own business you might take a reward but you also take a big risk and that is the nature of business, isn’t it? You reward risk because you’re taking a risk.

Baroness Hogg: Absolutely.

Teresa Pearce: Whereas the perception is that when the risk comes home to roost it is people much lower down that take the fall.

Baroness Hogg: And lose their jobs, yes.

Q26 Teresa Pearce: Yes, and people at the top just take the reward or the payoff or, even if it’s a termination, because of the terms of their contract there is never a failure. Do you think that affects public confidence in the banking sector?

Baroness Hogg: I can’t remember if it was Peter or Sir David made reference to the point that shareholders have perhaps been inactive on this issue because, at the end of the day, however big that number for the chief executive, in terms of the overall numbers for the company it might not have seemed very large. But certainly there were institutions coming up to and through the financial crisis where simply an awful lot of the economic rent was going into the hands of those at the top of the business, and not into the hands of the shareholders. At last I think the shareholders began to wake up. They wanted more power to vote on these issues and that has changed.

One of the things that, in the BIS consultation, we at the FRC are trying to help BIS with is this business of articulating clearly and understandably what is being paid. That may sound like something that ought to be very simple to do, but in fact, with things like long-term incentives, putting a clear value on what that is when it’s granted so that the shareholder, for a start and then the public, can see what is being granted is very important and a better discipline and a better framework for doing that would make a lot of difference.

Sir David Walker: Chairman, could I make three additional observations here. One is that in relation to the regulators, for board members in particular, but also executive board members, a huge amount has been done in the last two or three years to improve the balance. The point I have in mind, in particular, Ms Pearce, is deferment. Increasingly these variable awards will not crystallise or become payable until after a period of time and, frequently, the period of time is a function not only of years but also of performance during that period. So if there is bad performance the award does not vest or crystallise.

The second thing I would say is, looking ahead, regarding what BIS are said to be looking at-and I have to say in some of the evidence I have suggested, I have been very supportive of it-the process would be greatly helped by reducing some of the complexity of these remuneration structures by having a single figure. Having a single figure is not easy. There is an immense array of valuation questions that arise, but if we can get to some agreed single method of measuring that produces a single figure, that would be an advance in this space.

The third and last observation I would make relates in particular to mechanisms to increase the sense of responsibility of board members-I am thinking here of nonexecutive directors. I think there is quite a case for deferment of some part of the fee of non-executive directors. I think, in relation to Mr Norman’s question earlier, it may be that, going forward, non-executive directors in these financial institutions need themselves to be paid rather more. If that is to happen, I would make it a condition concurrent that there is deferment of some part of their fee related to not only time but performance over that period.

Q27 Mr Mudie: Peter, can I just ask you, the ONS figures are very interesting. They show that pension funds and insurance have gone to 14% of the value of the stock market-you are nodding, you know where I am going-the lowest figure since 1963, when the service started. Secondly, on individual ownership, UK-owned has gone down to 11% from 16.5% since 1998. At the same time, overseas holdings have gone up from 31% to 41%. Now, that is the overall stock market. Are those figures reflected in the financial sector?

Peter Montagnon: I think they almost certainly are. The problem is there are no real breakdowns and we have been trying to do some work to drill a bit deeper into the detailed breakdown of ownership and it has proved very difficult. It is very difficult partly because there are two strands to this; first, who owns the shares and, secondly, as it were, who manages them? The person who manages them may well be voting them. What is clear is the ownership in the pension sector and the insurance sector, as a result of a number of regulatory factors among other things, has come down very sharply. It is clear that the ownership abroad has gone up a lot.

It is not entirely clear to us that the retail ownership is as low as the ONS suggests, but we, as I say, have really had quite difficult technical problems in developing the information, but it is also true that the fund management industry in this country still disposes of quite a lot of votes. So there is, in all that, still a possibility to encourage the larger fund managers to exercise their stewardship responsibilities in general meetings and they still, I think, have quite a lot of clout with the companies. The Stewardship Code, which we have had running now for two years, has encouraged them to exercise that clout, which I think, through the shareholder spring, you are starting to see.

Q28 Mr Mudie: Thank you. Sir David, with the movement in ownership and especially the increased overseas investors, do you see advantages and disadvantages in that and, if so, could you spell them out?

Sir David Walker: Mr Mudie, this is the tip of a very large and, I think, problematic iceberg. I think this is very, very serious stuff, if I may give two or three dimensions of it. The role of long-only investors has diminished greatly in the last, say, 15 to 25 years, or 10 to 20 years. As Mr Montagnon says, the figures are not as good as they ought to be. What we do know is that the turnover in bank stocks on both sides of the Atlantic, in Europe and in the United Kingdom and in the United States, has increased very rapidly in the last five years, since the beginning of the crisis. This is, in part, a function of high-frequency trading where, quite commonly, the stock is bought and sold in less than a second. This is the antithesis of the long-only concept. I mean, the chairman doesn’t know who his shareholder is between the beginning and the end of the sentence. That is very serious.

Another phenomenon that is closely related to this, Mr Montagnon mentioned it, is the increased intermediation between the ultimate owner, who may be a pension fund, of course acting on behalf of its/his/her beneficiaries, and the board, which is the agent; the increased interposition of the fund management community who fund manage far, far more of assets and equity holdings than are being managed through the agency of a fund manager. That is a good thing you could say, taking your question, in the sense that the management is more professional. It is not without conflicts of interest that may be at times extremely serious. There may be circumstances, I know they arise, where a fund manager who is managing to a benchmark and has a holding in a stock that is lower than the normal, but the benchmark relationship is short or light in a particular stock-his interest to perform to the benchmark, or better than the benchmark, is that the price of that stock goes down, not that the price of the stock goes up.

So there are conflicts of interest in the fund manager community that are serious and those, coupled with the problem that we touched on in the exchange with Mr Thurso, of myopia, which I think is much more serious now than it was a decade or two decades ago, mean that the focus on trading in the short term and the absence of adequate attention to the stewardship responsibilities on which the FRC, in my view absolutely rightly, are placing focus is a big problem. So the ways and means in which, in particular but not only for financial services entities, more flesh can be put on the bones of stewardship I think is a big agenda.

Q29 Mr Mudie: I was going to go on, but I think you have covered it. The hedge funds tend to be short-term. Sovereign wealth makes this a systemically important sector. There are additional factors, but it all amounts to the necessity to take some specific action. You are obviously alive to the problems. Your lecture in Beijing indicated no concern, but a wish for better stewardship from overseas investors. Are you firming up a programme of action or anything to deal with it, particularly in the financial sector?

Sir David Walker: I am sure Baroness Hogg and Mr Montagnon will speak more widely, but my own view of the financial sector is that there is very limited scope for regulatory pressure or initiative in this space. If you take the group that is becoming rapidly more important and naturally, the sovereign wealth funds, it is very hard to require them to behave in particular ways so long as they operate within the law and the regulatory framework. They just wouldn’t come.

This is very much a matter for the FRC, but I do think there are things that can be worked on over time. If I give just one example, I think that pension funds should be strongly encouraged to be much more demanding in their mandates given to fund managers to manage their money, in requiring them to have a corporate governance capability that engages in an active way in all this stewardship stuff. That does not happen adequately at the moment, so that is a door that needs to be pushed further open. Then there are other examples.

Mr Mudie: Baroness Hogg was showing an interest before.

Baroness Hogg: Yes, if I may. First of all, against the background you and Sir David both so accurately describe, it was, in a way, remarkable that a group of long-only or mixed institutional shareholders were prepared to put their energies three years ago into the development of the principles of a Stewardship Code, because you may remember the origins of this was the institutional investors doing some work on this. The Government asked us, at the FRC, to take on responsibility for monitoring, reviewing and, if necessary, developing the Code. We said we would only do so not just if the Government asked us but if the industry did too, because if the industry was not signed up, frankly it was not going to go anywhere. We were then very impressed by the rate of signature, largely thanks to the hard work of Peter and one or two others, to the Code. So we are now up to, I think, 250 signatures; by no means, by the way, only UK institutions, and it has been important that we have had some support from significant US institutions, for example.

With reference to the sovereign wealth funds, though they are not prepared to sign up in public for reasons we know well-for fear of being seen to be politically interfering-none the less, the principles underlying the code they subscribe to, and they were prepared to discuss with us the activities going forward. But we have now seen action to demonstrate that signature isn’t just a sort of "must do" to keep Government and regulators quiet. That is going to be the testing period for the Code, I think, and we produced our first report on the workings of the Code early this year and said that this was very much stage 1. We now need to see action.

I think the key thing is for shareholders’ approach to corporate governance to be embedded in the asset management and stock selection process, not to be seen as an add-on. There is too much danger that it is put in a box with social responsibility as something we do if we have time and money. We have been talking to those who give the training programmes, in particular for asset management, to see if we can get a greater sense embedded in the training to say that corporate governance is important to how your assets perform. There was a thought to begin with, for example, that the index funds would have no interest. In fact, they have probably had the greatest interest of all because they can’t trade out of the stock. So getting that embedded in the core of asset management, as opposed to seeing it as some kind of add on if you have the time and money, is essential to making this work.

Peter Montagnon: Sir David said something about the tendency of trading volumes to go up, and of people to regard the ownership of shares as owning an instrument you can trade, rather than something which confers ownership. I do think there is something quite important here with regard to the balance between regulation and governance in the banking sector, namely that if everything shifts to regulation the shareholders are out of the loop and they will increasingly see the pieces of paper they have as instruments to trade, rather than ones which confer ownership, and we shall lose from that because the consequence, in the end, would be that they would see possibly less point in putting in more capital. The example we are seeing at the moment of this is the proposed CRD4 directive in Brussels, which defines certain corporate governance standards for the boards of banks. For example, they would have to separate the chairman and chief executive’s role. They would be able to get a waiver, according to this directive, from the regulator, but the shareholders no longer have any say. I think there is quite a danger in going too far down that route because, if shareholders don’t have any say, all they can do with these instruments is trade them and then we are losing a very important dimension and, as I say, one which ultimately is an encouragement to put more capital in when it is needed.

Q30 Chair: Baroness Hogg, do you think that there is any merit in asking the shareholders who hold shares in systemically risky institutions to play a much more activist role in the appointment at nominations committees of these firms and, in particular, the chairman and the senior independent director?

Baroness Hogg: I think institutional shareholders are much more interested in particularly those roles that you describe and one of the important changes in the 2010 Corporate Governance Code, in the Stewardship Code itself and, hopefully, in the way that people see these activities is the re-emphasis on the role of chairmen. You know, it used to be the case that the institutional investors saw the chief executive, sometimes the finance director, and very rarely the chairman. Then you went through a phase where chairmen used to write to institutional shareholders saying, "Would you like to see me?" Because everyone has busy diaries, either there was no reply or the answer was, "No, don’t let us bother". Now chairmen are becoming much more active in writing to their main shareholders and saying, "Look, over the next three or four months-it is not urgent tomorrow, I am not sending a signal-I would like to see you to make sure that I maintain a dialogue with you going forward", so that the separation of powers at the top of the company, which is so important to the UK system, becomes more connected with the shareholder base. Can you take it more widely? I mean, there is an argument that the chairman of the Audit Committee should have a much greater connection with shareholders. Yes, we would like to see that, but we are not aiming for the too difficult at this point.

Q31 Chair: I am asking you a specific question: whether that greater connection could be reinforced by attaching it to influence over the appointment of these people in the beginning. After all, it is, isn’t it, in the nature of things that people who have been appointed to a bottom-end FTSE 100 company board as a non-exec might quite like, one day, to be appointed to a more senior one? At the moment, the flow of decision making generally comes from the chief executives of these firms, who talk among themselves about how so-and-so is getting on their boards. I am suggesting, might there be merit in encouraging shareholders to play a greater role in that process so that the potential for moral hazard, that is group-think, being absorbed by those people appointed who are keen to keep the right side of the chief executive is diminished and, therefore, the scope of the challenge is increased? Sorry, that is an unusually long question.

Baroness Hogg: No. I think the chat is chairman to chairman much more than chief executive to chief executive. My experience of chief executives is that, even if you are to be within that pool, they don’t know that pool as well as the chairmen do and the chairmen-

Chair: But I mean the more general point.

Baroness Hogg: But your challenge about are they just appointing people like themselves from within this pool, I think, certainly with respect to the appointment of chairmen, it would be a very foolish SID now who did not consult shareholders. I mean, shareholders vary in the degree to which they wish to be consulted. Some of them have Chinese walls between a full corporate governance function that you can go and talk to without putting that shareholder offside in the market.

Q32 Chair: Yes. I will have one more go. What I am asking is, should shareholders in systemically risky institutions, which carry an implicit guarantee of some type and some protection, have imposed on them a duty of some type or be encouraged to assume a duty of some type to turn those wishes into action, to be much more proactive in this field?

Baroness Hogg: I think within the Code you can put encouragement-a formal duty, for example for them to be members of a nominations committee-

Chair: But are you supportive? I am having yet another go. Are you supportive of encouraging it?

Baroness Hogg: I am supportive of encouraging much more engagement with shareholders on significant appointments to these institutions, but I am wary either of having a formal process imposed on shareholders that they probably, many of them, would not fulfil and I am wary of thinking you can drive that too far down the board. So I would say absolutely the chairman and, of course, the chief executive and I do believe that major consultation goes on on these appointments now. Whether you can take it to every non-executive, unless-

Q33 Chair: I am asking a specific question in order to try and find a way of augmenting non-executive challenge on boards, which failed miserably in systemically risky institutions in this crisis.

Baroness Hogg: Difficult. I am not sure that the shareholders are going to do a better job than the nominations committee in this regard. Shareholders are pretty inclined to like names they know on the boards of other companies, so I wouldn’t be putting too much weight there at this point.

Chair: Sir David wants to add something.

Sir David Walker: Well, I hesitate to take a harder line than Baroness Hogg, but I think on this I do, slightly. I am very sympathetic to what you propose. The Swedish model of involvement of shareholders in nominations committees is specifically appropriate to Sweden, because there are very few shareholders and they all begin with W.

Baroness Hogg: There are few directors and a very small pool.

Sir David Walker: Yes, so we shouldn’t press the analogy too far, but I think there are a number of specific things where we should expect more from the shareholders and have chairmen readier to respond. So I think the game needs to be upped. The three examples I would think of are making it, not a requirement-of course, I agree with Baroness Hogg, you can’t make this a regulatory requirement; but establish as a clearly understood best practice that the nominations committee, when thinking about appointments of some seniority, the SID, the chairman, the chief executive-I am not sure where I would draw the line. You may want to go beyond that. Changing the composition of the whole board would have a degree of obligation. It would be the normal best practice to talk to the major shareholders. Who are the major shareholders? Is it two or three? Do they have 10% or 15%? I am not sure, but that is worth thinking about.

The second thing, when you define the group of major shareholders, I think I would propose, not just in relation to nomination, to create an obligation, if you like, on the major shareholders to make a presentation to every board in which they have a significant stake once a year in transmit mode-not learning, but a telling the board what their concerns are about its composition, about its strategy, what is going on. The board don’t have to respond. All they have to do is listen and they would learn something they are not learning by methods of transmission at the moment until it is too late. If you think of some recent instances, not particularly in financial services, it is pretty clear the board did not know about the extent and depth of concern of major shareholders. My understanding, though it is incomplete, is that that was the case in one of the pharmaceutical companies, AstraZeneca, though I am not intimately in the know on that.

The third and last thing that I think would be a really good practice to institute, and it is not adequately pursued at the moment and it relates to the central importance of the chairman and the board, is that the corporate broker should, with some regularity and frequency, report to the whole board, not just to the chief executive. Of course, the corporate broker likes reporting to the chief executive, which is the common pattern, though not without exceptions at the moment, because the chief executive is normally the source of mandates to do something for which the investment bank gets paid. So I think we need to promote the independence of the corporate broker and have him or her report to the board on the views of the shareholders with whom he or she is critically and continuously in touch.

Baroness Hogg: I do believe this happens pretty regularly now, that last point, and I think it is important, but I think allowing the broker to come as an intermediary too much between the board and the shareholders can be a little dangerous. David, I don’t think you are any more ambitious than me on this because I think, with the normal diversification of share ownership around a major company now, two or three shareholders is not nearly enough. You won’t begin to get at a slice of your shareholding base unless you go to 20 and that is the kind of level we are talking about.

Q34 Mr McFadden: Following on from George Mudie’s question about the changing patterns of shareholdings, more sovereign wealth funds, more foreign ownership, you refer to high-frequency trading where shares are bought and sold within a second. If all of that is militating against engagement and stewardship, what is going on with the shareholder spring? Why is that happening? Could I start with you, Mr Montagnon?

Peter Montagnon: Well, first of all, I think high-frequency trading is possibly a little bit of a red herring in this regard. The volumes are very high, but it may only affect a small slither of the total capital, which is just turning over very, very rapidly. So there is still a very large chunk, the majority, which is perhaps in more conventional hands. I think, as I said earlier, that if you add up the voting power of the big institutions it may not be as large as it was, but they have significant voting power, which they are starting to exercise. I think one of the reasons they are starting to exercise it is that they have seen from the public reaction in areas like remuneration that there is a responsibility expected of them to take these issues seriously, and they are beginning to do so because they have reputational risk if they don’t.

I think the other issue may be that, in terms of a world where the economy is not exactly booming, the less good performance does tend to stick out and become more obvious and I think there is, therefore, possibly more reason for them to become more involved. I would like to see the sovereign wealth funds engaged in this process because it is quite clear they are larger, long-term holders and they are a new presence but, as Baroness Hogg has said, this is really quite difficult to require of them. They do not want to put their heads above the parapet in public, but what we do find when we talk to them privately is that a lot of them are quite supportive and what we are trying to explore over time is a way of making them more comfortable with making that support a bit more known to the people who are operating on their behalf, the fund managers and so on, where that is relevant. I think it would be also, in my view, sort of quite interesting if sovereign wealth funds began to take more of an interest in holding stakes in, for example, big British banks.

Q35 Mr McFadden: To help our understanding, are you saying that the forces behind the shareholder spring have tended to be what we would regard as the traditional institutional shareholdings of insurance companies, pension funds-

Peter Montagnon: Yes, I think that is right.

Mr McFadden: -and so on, and the sovereign wealth funds have slightly been standing back, watching this develop?

Peter Montagnon: We don’t know exactly who voted what, but my belief would be that it is the traditional institutions whose approach has been changing, as I say, partly because they have noted the views of the public and partly because they have seen things that they do not like, especially in the context of a weaker economy, that they have started to pick up more. But it does not mean that the sovereign wealth funds can’t become or should not become more involved and I think, were they to become more involved as holders of large British financial companies, it would be very good to see them apply the principles of stewardship as we would see in the Code, even if sometimes that will be rather more privately done than publicly.

Mr McFadden: Do either of you want to come in?

Baroness Hogg: I think they are also in a mood of feeling that it is "use it or lose it"- that if they do not exercise shareholder responsibilities, then the argument for transferring those kinds of rights to regulators will intensify, and we see some evidence of that in Continental Europe. So they are waking up to that, too.

Q36 Mr McFadden: Well, that is an interesting point. I mean, to put it in sort of layperson’s terms, do you think the shareholders are waking up because they have the Secretary of State for Business breathing down their neck?

Baroness Hogg: I would think it was more Europe breathing down their neck, because the waking up has gone on over there the past couple of years, and we have a couple of European documents out there at the moment that are relevant to these issues that would transfer what has traditionally been seen as shareholder responsibilities or board responsibilities to regulators.

Mr McFadden: Sir David?

Sir David Walker: The only observation I would make is a slightly different one. My sense is the Committee and certainly the three of us on this side of the table, I think, agree that we want to find sources of capital who take a long-term interest along the line of sustainability of the enterprise and most of our discussion is about the equity holders, the shareholders and the little problems of high-frequency trading and interposition of fund managers in the process and so on. One question that I think will need increasingly to be addressed, particularly in the financial service space-I think it is desirable that it be addressed and I have some views about the resolution-is the absent friends, the bond market, the providers of credit through the markets, which are much less significant in the UK and in Europe than in the United States.

But they have a naturally long-term interest, like the sovereign wealth funds, in the wellbeing of the companies to which they provide credit funding. I think a really important question is, when a company is changing its chairman or chief executive or embarking on a big strategic initiative, a big disposal or acquisition, whether a major bondholder should not have some say in the process. The reason I see that as potentially quite an attractive avenue, the complexities of it are very great, is that the bondholders typically don’t trade stock and don’t trade their bonds. There is very little liquidity in the bond market. They are naturally long-term holders getting yield. If they could exert some influence on some of these matters that are relevant to sustainability and take attention away from immediate short-term performance, that I think is a potentially very healthy development.

Q37 Mr McFadden: The public will, I am sure, give three cheers to the idea that shareholders are finally doing what the public thought they ought to be doing all along, and will be surprised at the degree of relaxation over the years as reward built up and up and remuneration committees just seemed to have had a course of, "Oh, we will just rubberstamp what came along". If this movement continues and there is a greater focus from shareholders on all these different types on pay, are there any dangers in this? Are there any dangers that they are focusing on pay so much that there may be other areas of the company’s performance that they ought to be looking at, or should we give this an unalloyed three cheers? Just quickly. Sir David, I will start with you.

Sir David Walker: My answer to your question is there is a danger, yes. I mean, if we look historically at the causes of the crisis, which have been discussed in this room before the Committee many times, there are many causes of the crisis and many elements, and undoubtedly misalignment of incentives, which is really what we are talking about, was among them, but it was not the only thing. If we now look forward, the areas of influence in the development of banks, but also other corporate entities, go well beyond remuneration and they have to do with, "Is the strategy that leads you to an M&A proposition a sensible strategy?" Now, shareholders should be more involved in that sort of proposition than I think they have been in the past. They should be more involved in the composition and performance of the board, to which there should be better accountability from the board.

Baroness Hogg: I will give you a quick yes, there is a danger that too much energy is focused in that area. If BIS-our financial reporting lab is trying to help with this-can help to simplify the communication on remuneration, so that there is a number which is reasonably understandable and which both sides can agree properly reflects what is being paid, that may shorten the dialogue somewhat, because an awful lot of the dialogue is about, "Well, what exactly does this mean?" But yes.

Peter Montagnon: Yes, absolutely, but I would add one thing, which is that I don’t think we would regard it, in terms of the Stewardship Code, as a success if what we did was create a huge number of public rows continuously, because where we want to be at the end is for these matters to be dealt with through proper communication and dialogue between companies and the people who provide their capital. I mean "dealt with" so that the companies are going to listen through that dialogue to what the shareholders are saying, rather than big rows emerging. So there are going to be times when the challenge is made to the public, but I think if we measure the success in shareholder engagement simply in terms of the number of rows we have had this year, we are missing the point, because what we want is a better, holistic relationship.

Mr McFadden: Most of our constituents would probably argue that the way to avoid rows is to be more reasonable about pay right up the cycle.

Peter Montagnon: Well, I think that is right and I think that one of the issues in all of this is you need to be consistent through the cycle, because in the boom time it is very much harder to challenge this sort of thing. It is easier in a recession and I think both sides need to look for consistency through the cycle. I think that is right.

Q38 Mr Ruffley: Baroness Hogg, could we turn to the possible downsides of greater shareholder engagement? Douglas Flint of HSBC gave evidence to this Committee and he put it rather graphically. He says there was a great deal of pressure coming from shareholders who were looking for enhanced returns and were pointing to business models that have, with hindsight, been shown to be flawed and, in particular, very leveraged business models. They were saying, "Great. You guys are inefficient. You have a lazy balance sheet. There are people out there doing much better than you are", and there was tremendous pressure during 2006-07. Do you think things have got better since the financial crisis, having regard to what Douglas Flint has said?

Baroness Hogg: First of all, I think the more thoughtful of institutional shareholders will recognise, not totally but to some extent, that they were part of the problem as well as everybody else-that their pursuit of short term-ism did not in every case encourage a focus on long-term sustainability in the way that David described, absolutely. Has it got better? Well, to some extent there was some learning from that. The short-term focus in asset management, of course, has not entirely disappeared. One of the reasons why I think both Peter and David mentioned bondholders is that having them as part of the mix of engagement can be quite important, because clearly their perspective is totally different and is not driven by the same short-term equity performance agenda. Nothing is going to be a perfect solution here, but the equity owners are the equity owners and to lose the chain of accountability to them, I think, will be damaging to the system and damaging long term to the provision of equity capital.

So, no, I don’t think they are always going to get it right by any means and the best of them fully realise that. That is why to some extent they don’t want to be pulled too far into the board job. My dialogue with the Chairman on the relationship between shareholders and board-it is a delicate issue. "You can’t, at the end of the day", shareholders say, "ask us to do the board’s job. Then, what is the board there for?" At the same time, a good board has to make the argument back to the shareholders-and Douglas Flint is a good strong personality, perfectly capable of doing that-as to why they think the shareholders are, in this case, not looking to the long term.

Q39 Mr Ruffley: Now, part of the problem of short term-ism in some people’s view is that asset managers are assessed on their performance quarterly or half-yearly. Could you just go through, again, what you think can be done from the FRC’s point of view to address that?

Baroness Hogg: One of the issues I think from the stewardship side is precisely this. One moment we are talking about remuneration within the companies and whether that is excessively short term. This is an issue, of course, about the incentives that are embedded in the asset management business. As the dialogue on stewardship increases, those are some of the issues I think we are going to have to be able to take further with signatories to the Code. I don’t know, Peter, if you would like to respond on that or whether I have dragged you too far on that one.

Peter Montagnon: No. One of the problems in this is people say "shareholders are all short term" as if they were all the same. They are not. In the Stewardship Code, what we are trying to do is sort of identify and single out and, if you like, both put obligations on but also nurture the longer-term element, which is undoubtedly there, and that, coming back to what we were talking about earlier, does include sovereign wealth funds. I have heard people from the Nordic Investment Bank say their time horizon is 50 years. They are not very interested in just short-term returns for the sake of it, but I think that there is an area here which is important. Sir David has already mentioned it and it is something we have taken up in our dialogue with the European Commission, which is the question of the mandates that are issued by asset owners to asset managers to manage money.

I think at the very least it would be reasonable for people who do issue mandates to be able to show that they have considered the time horizons under which they are looking, their investment objectives, and factored those considerations into the nature of the mandate they have given. This would be, if you like, an extension of the Myners principles, which were much discussed over the last 10 years or more, and could apply to more than just pension funds, because there are others who do issue such mandates. The mandate question is not necessarily one for us. We don’t have competency there, but we, I think, would feel that if there was some grit in that part of the chain, that would help the stewardship process work and we would support it. I think, therefore, looking at people who issue mandates and expecting them to say more about what they really want in relation to what the needs of their beneficiaries really are could be very helpful.

Mr Ruffley: Sir David, anything you would like to add?

Sir David Walker: Just two things, Mr Ruffley, briefly. Those are different points. On your first question about leverage and the so-called efficient management of the balance sheet, which some banks were seen not to get or whatever, the regulatory tightening that has happened on the Basel III and the introduction of leverage ratios and all the rest, which is in prospect, will be very significant and it is not going to be possible to see banks with leverage of the kind that they had before and during the crisis.

The two sources of the myopia we have talked about-I mean the two legs on which this disagreeable thing stands-are quarterly reporting by corporates, and we have had over the last 25 years the pursuit of virtual transparency, which has been, I think, uncritical and more frequent. The consequence of that has been to force chief executives and boards to be much more attentive to what they are going to report at the end of March, at the end of June and September and so on, and I think it is consistent with this taking of a long-term view. I have no idea whether any of that can be rolled back. It is now too deeply entrenched, but I think we should be clear that it is one of the major contributors to the myopia problems.

The other one, which Mr Montagnon has just been talking about, is the focus of fund managers in the mandates that they are given on their quarterly and sometimes even more frequent shorter-term performance, which is something that in part-it is not an apportionment of blame-has been facilitated by technology. It is possible to know how you are doing or your portfolio is doing vis-à-vis the benchmark at this moment in time, which used not to be the case. So that has reinforced the situation.

I do think that an important area for initiative-this is complementing what Mr Montagnon said-is to have a dialogue with the pension funds and other potentially long-term investors on the nature of the specification in their mandate and what it is they want. The people who are very influential in that process are the consultants, who are invariably consulted by pension fund trustees on the nature of the mandate they should give and which fund manager they should give their money to. I think there is a dialogue in that space that is really important, which I think has not taken place.

Q40 Mr Ruffley: Just one final question for you, Sir David. It has been suggested that one way of tackling short term-ism is to introduce differential voting rights, which would increase the power of long-term holders of shares. What do you think of that proposition?

Sir David Walker: I understand the principle that leads to the proposition and it is a practice that exists in some countries-in Scandinavian countries, for example, and in particular in Sweden, which I know a little about. I think in practice, it would be extremely difficult, extremely bureaucratic and complicated, to find a way of implementing it. I was involved in Legal & General, which is the biggest equity investor but mainly a tracker fund, a passive investor in the UK, where pension fund moneys and insurance company moneys were all mingled in the management of a stake in BP or whatever. The particular beneficial stake of one pension fund as against the many other pension funds in those portfolios would change over time in a way that would make it extremely difficult to attribute or assign to one ultimate shareholder an extra 25% weighting. So, with some regret I have to say-I see the attraction of the principle-I think it would be close to a nightmare to try to implement an arrangement of that kind.

Q41 Mr Love: Can I come back to the issue of executive pay? We have touched upon it all the way through, but I want to focus on it in my questions. Baroness Hogg, in response way back at the beginning, if we can remember that far back, when someone posed to you whether it should be primarily shareholders’ responsibility or should regulation take effect, you said, "We need both". What do you think we need in order to have a better handle on executive pay?

Baroness Hogg: When I made that remark I was talking about the whole spectrum of regulation with respect to major financial institutions, but it holds good, I think, in this area too. I think the first thing we need is greater clarity and transparency-it may sound a small ask, but it is quite difficult-on what is being granted in terms of reward to each executive on which remuneration is reported. You have two different pressures working here that work against each other in a slightly unhelpful way.

Shareholders increasingly, and you can see the arguments, want long-term incentive awards to have a lot of performance conditions attached to them. That makes the scheme itself much more complex. You know, you may have dual indicators: is it EPS and total shareholder return that are the two variables hitched on to a particular award? That then makes the valuation of this particular award more complicated. It then, in my view, can lead you down a path where what the company may be spending in order to create this great incentive architecture may be much greater than the value ascribed to it by the person to whom it is granted. That was the interesting report, I think, over the last week indicating this. So they may be actively wasteful in terms of company money and delivering incentives.

So you have that increasing complexity, driven by the understandable and correct desire to link these awards to performance, working against simplicity and clarity about reward. I think if we can at least crack the transparency issue and the way these numbers are reported, we may make it easier to make comparisons to what is granted where, because an awful lot of this upward ratchet that has been so rightly discussed is people picking numbers from each other and maybe not having a good enough analysis by remuneration consultants to show the weakness in these comparisons-picking the best bit and, therefore, demanding that they should have the same to put them in the right place in some hierarchy of remuneration within their industry, which has been an upward ratchet. I believe complexity has helped drive that transparency and complexity. We must have the transparency, but if we can get greater clarity and simplicity on the numbers that, I think, will help.

Q42 Mr Love: I understand that. Let me take you just a little bit to a slightly different place and that is the role of shareholders. As Mr McFadden mentioned, the Secretary of State has been pontificating on the role of shareholders. There are others who think shareholders should be required to disclose what they do in relation to pay and indeed other matters. Do they have merit? Will they make a difference to the role that shareholders are currently playing?

Baroness Hogg: Well, I think now that shareholders have become more active and more sensitised to these issues you will see shareholders taking action that cuts through a lot of this and says, "Look, I don’t care exactly how all these numbers hang together. I just think it is too much and I am therefore going to vote against the chairman of the remuneration committee, the chairman, the executives receiving it and the remuneration report". Once you begin to get those signals, there falls back on the company the requirement to look again and reduce the scale of remuneration. There are a lot of weapons out there now for shareholders. We just have to see how they use them and try and make it simpler for them to get to grips with the numbers.

Q43 Mr Love: Can I come on to you, Mr Montagnon? Earlier on, when you were asked about remuneration committees and remuneration consultants, you suggested that the ratchet really was the consultants. What should we do about that?

Peter Montagnon: Well, the consultants have produced a code of practice, which has had a first iteration and I believe is having a second iteration. I think that would be quite important to pursue, but I think the other point is that we need to be clearer, in terms of the governance hierarchy, who appoints and as it were runs the relationship between the consultants and the company, because there has been a blurring in the past of responsibilities here. The consultants may have been brought in by the HR department, who are part of the executive, and then end up working for the remuneration committee. I think an important step forward would be to be absolutely clear that the remuneration committee would appoint the consultants and be responsible for the relationship and make sure that the conflicts of interest, which might arise if the consultants were working across the business, are being addressed. That doesn’t happen at the moment.

Q44 Mr Love: Let me just interrupt you. There has been some concern about cross-selling of services and, therefore, conflicts of interest. Do you think that that needs to be dealt with?

Peter Montagnon: I think that sort of thing would be dealt with more easily if it was very clear that the remuneration committee-which, by the way, under the Code, is made up of independent directors, for example, separate from the executive-had a role in overseeing the relationship. Conflicts of interest will be part of it, and the work that the remuneration consultants might be doing elsewhere in the company would be subject to some form of approval process.

Baroness Hogg: I would take a slightly stronger view on that one. I think the remuneration consultants who work for the committee should do no other work for that firm at all, and that means, for example, that you should not use your auditors. That goes to another set of issues we are currently debating, which is, as you rightly say, prohibiting or severely restricting the use of your auditors for nominal-

Q45 Mr Love: Let me come on to remuneration committees and, in a sense, non-executive directors because there have been quite a lot of concerns that there is a relatively small pool of people from which non-executive directors are chosen and, therefore, remuneration committees, which depend on non-executives, are chosen. Let me ask you two questions. First, should we be going outside the normal channels? Should we be saying that they have to advertise for non-executive directors as a mechanism to widen the pool?

Baroness Hogg: For private companies, I think making a requirement for an advertisement for every member of the board I would not favour, but I do think that you do have to have very disciplined processes to ensure that you are not simply appointing someone like yourself.

Q46 Mr Love: There are some organisations-Pirq seems to ring a bell-that specialise in non-executives. Should we empower them to widen their pool to try and find people with appropriate qualifications? We do understand, particularly with larger companies, you do need expertise in this field. I am really asking, if we do not advertise, how do we widen the field? How do we bring in new and alternative views so that we don’t get group-think?

Baroness Hogg: Yes, absolutely. My personal experience is it is harder to find a good chairman of remuneration than it is to find a good chairman of audit, because there is a whole profession producing people with expertise in audit, of variable quality no doubt. But to find a good chairman of rem who, in the current climate, too, is going to be taking most of the rotten eggs-

Chair: They take all the flak the whole time.

Baroness Hogg: Exactly. Finding good, strong people to do this is really hard.

Chair: Internally, as well.

Baroness Hogg: Yes, exactly. I do not think advertisement would do it for you, but I do think you have to be very challenging to your appointment consultants, to your head-hunters-to go and find you a really good slate for appointment of a good remuneration chairman. Women tend to get that short straw, by the way, if you look around the place.

Q47 Mr Love: Let me come on to slightly more thinking about remuneration committees. The recent High Pay Commission has suggested that we ought to look to an employee representative on remuneration committees. Now, that is a departure from previous practice, but it is an interesting idea. I just wondered what you think the advantages and the disadvantages would be of taking someone who is employed by the firm, but one would assume not a trade union official, and placing them in that particular role, which is quite a demanding role.

Baroness Hogg: I do have experience of that. I sit on the board of the John Lewis Partnership where there are five directors elected from within the partnership, the employees, who sit on the board and sit on the remuneration committee, but they very clearly sit there as owners of the business and I think that is the chain of accountability you have to maintain in these board activities.

Q48 Mr Love: Sir David, you have been very silent so far. How do you respond to these questions? I know there is some real concern that Europe is taking very much the regulatory route rather than the other route. How do you find the balance on placing responsibilities on the shareholders?

Sir David Walker: Two observations I make. First, although there has been a lot of publicity, absolutely understandable, around the shareholder spring-which is related to, directly and prominently in the public domain, eight or 10 companies or perhaps less than that-I am absolutely sure that every chairman of every FTSE remuneration committee is, in some degree, quaking in his or her boots about where they are and what they have to do to ensure they don’t get mired in this sort of attack or publicity next time round. So I think the demonstration effect of what has been happening we can reasonably expect will be very powerful and we will see the benefit of that.

The other observation I would make in relation to your question about involvement of one or more employees on the committee is that I chaired a remuneration committee until last year for five years, and I am pleased to say we got the award every year for the best DRR in the FTSE or whatever it was.

Baroness Hogg: Fatal.

Sir David Walker: I am not sure it would be. I am no longer chair. I think it was Reuters, but I am unsure who did this survey. But, in my experience, I think the committee were very well aware of the attitudes of staff and, while I unreservedly agree with the point that is being made by Baroness Hogg about the independence and accountability of the consultant to the remuneration committee chairman or to the committee, and not to the executive, I think to have the committee serviced by a very good HR capability that says, "Well, if you do this, it will cause this tension or that tension", was something I found to be very valuable. So I didn’t feel the lack of employee input. I knew in that organisation, of course, it was filtered through the HR department, but I found it to be dependable. I knew what the attitudes of employees were likely to be.

Q49 Mr Love: One final question to Baroness Hogg. It is really this issue about Europe. If we are to resist the blandishments of saying that, "Oh, we will just regulate our way out of this", with the prospect that shareholders and others responsible will say, "Well, we will leave it to the regulators", how do we do that? We have Mr Barnier coming soon, so you could perhaps give us some hints.

Baroness Hogg: Yes, indeed, and we have to demonstrate that our system works well. I mean, we believe that a "comply or explain" corporate governance code has worked well in the UK to drive best practice forward faster than in many other jurisdictions. For example, we move faster on independent audit committees. For example, if you make a comparison with the US, and this may be rather pertinent at the moment, we moved faster towards separation of chairman and chief executive, that essential separation of powers at the top of the company. Annual election is another example of how a Code can move faster than the legislative process, because you don’t have to move at a speed at the back of the convoy. You can set out their best practice while saying to everybody, "If you think you have a good reason for not conforming, you can not conform provided you can explain it to your shareholders", and that provides the dynamic for change and allows you to move relatively fast.

We review the Code every two years in a way that legislation has to be a more detailed, slower process with greater definition of exceptions, if there are any. So we think a Code is a great, dynamic way of moving forward. We will also say, however, that you need a bedrock of hard law in this area and there is hard law with respect to listing particulars. There is hard law with respect to directors’ responsibilities in the 2006 Companies Act, which in some ways is much more extensive than directors’ responsibilities as laid out in other jurisdictions. So you do need a mix, but we believe that the dynamic of the Corporate Governance Code both maintains accountability to shareholders and allows the process and the setting out of best practice to move as new dangers emerge and new requirements for progress in this area are identified. That is my spiel to Commissioner Barnier.

Chair: Do come back to us on briefing for Barnier. We are always open to that.

Q50 Mr McFadden: I just wondered, on this question of one number and simplicity, whether there was tax and National Insurance advantage in the complexity that currently exists. Might senior executives resist one number because that would put them in the position of paying tax and National Insurance on their whole salary, simply in the way that all their employees have to?

Baroness Hogg: Well, some elements of long-term incentive schemes do have tax advantages attached to them. I still think that you ought to be able to arrive at a number that articulates the cost to the company, which is after all what shareholders care most about. The tax treatment thereof is then, I would say, a matter for the Treasury.

Q51 John Thurso: Can I just very quickly come back to this question Andy Love was pursuing on remuneration committees and the ratchet. I know you all completely understand that if everybody’s target is the bottom of the top quartile, it is only takes one for the thing to go "brrp" all the way through the entire system.

Baroness Hogg: Yes.

John Thurso: What we really wanted from the FTSE 100 and probably the FTSE 250 was for everybody to say, "No, we are all in this together. There will be no pay rises at all for two years". How do we get those chairs of remuneration committees to wake up and smell the coffee of the real world, which is that nobody should be getting an increase at all for some years because the system simply can’t do it? Do we have to get all 100 of them in a room and say, "Agree. You are not getting anybody a pay rise", because frankly, at over £1 million a head, none of them deserve it? How do we deal with that?

Baroness Hogg: I think you might well get a response in terms of base pay, and we are back to the complexity of the long-term incentive schemes.

John Thurso: It is a good start, as they said about the lawyers.

Baroness Hogg: Yes, it would be a good start, but it might not be very relevant to the final number that was received by somebody.

Sir David Walker: If I can just add to that, which relates to Barnier question, one of the most serious proposals in Brussels at the moment is that variable pay should not exceed basic salary. The consequence of that, if it becomes a regulation, will be to steeply increase fixed pay in up phases. So it will do precisely the opposite of what I think you are advocating, Mr Thurso. I think we should resist that very strongly.

Chair: Mr Montagnon, you wanted to come in very briefly.

Peter Montagnon: Well, I very strongly agree with what Sir David has just said, but the point is that for some time, in the immediate wake of the crisis, there was in a lot of cases a freeze on base pay, effectively. A lot of large companies didn’t increase it, but the difficulty and the complexity with this comes from the variable pay where the bonuses or the share incentives schemes pay out. Indeed, one of the issues about the single number is that you get wrapped into this sometimes pay that refers to several back years, but which happens to have just been delivered. I think there is a great difficulty the public have, and even the shareholders have, in distinguishing what belongs in which year. That is the main problem. There was not exactly a freeze, but there was for a while a great deal of restraint.

Q52 John Thurso: Is any executive in the UK worth more than £1 million a year? What is the point of it? It is just a measure of testosterone.

Baroness Hogg: I think you are on to a really important point: that some of these comparisons were absolutely just about-

John Thurso: Just pointless, yes.

Baroness Hogg: -"Don’t you value me more than the guy in the next company?" That is a real difficulty, but we all believe in transparency. I believe in transparency and I am sure the Committee believes in transparency, but one of the problems with transparency is precisely that it creates this issue.

Q53 Chair: When you have thought through the solution to the ratchet, please drop it on a postcard to us. We are very much in the market for it.

Baroness Hogg: We are spending hours with BIS on this at the moment to see how we can at least get the numbers in shape.

Chair: We are also very much in the market for thoughts about how to deal with European regulation and, indeed, any other issues that you feel should have benefited from more amplification today. Thank you very much for giving such excellent evidence. We appreciate it.

Baroness Hogg: Thank you very much.

Prepared 25th May 2012