The moment for reform
My chapter in Stewardship and the Stakeholder Economy: Perspectives on the Role of Shareholder Engagement in the UK Economy, published by PIRC
Capitalism is still in crisis and the shock waves from the near collapse of the financial system in 2008 are still reverberating around the world. This is the time to be asking fundamental questions about what we want from our market economy and how we can make it work for everyone. That debate must have the City at its heart, for though in this country the City contained the institutions which nearly brought our economy to total collapse; it also has the potential to lead the world in a reformation of finance.
The financial crisis raised deep, existential questions even in the City. Confidence collapsed in the system on which so many had relied. That brought peoples values and worldviews into the open. Suddenly even traders were asking what it was all for and whether we should be doing things differently. At the same time, a debate about market morality was beginning. The St Paul’s Institute, recently the focus of protesters’ ire, hosted speeches from UK and Australian Prime Ministers Gordon Brown and Kevin Rudd in 2009 on what values are needed in markets. A few months later, Archbishop Rowan Williams argued for virtue in markets. His speech seemed to have marked the closing of a window of opportunity for reform as banks returned to business as usual and lobbied against regulation. However, the European sovereign and banking crisis has opened that window once more.
The opportunity must be seized by the City, not least because it risks a populist backlash if it does nothing. The ‘Occupy’ protests and encampments have raised serious questions about how we ‘do’ markets and they were in financial centres because they identified finance as part of the problem and the solution. Their arguments should be engaged with. Meanwhile, the need for more bright brains in the City to focus on longer term investment horizons remains.
Promoting long term commitment and good management
The City is often criticised for being too short termist but this ignores the long term holdings held by many investment funds, such as pension funds. Some company managements may argue that investment managers are slow to back their long term business projects but the investment managers are not all to blame. Financial forecasting is not very accurate beyond a couple of years and while companies themselves may use forecasting models, even small variations in interest rates or the growth rate can translate into large variations in the net present value of a project today. Forecasts are also subject to trends. For example, during the dotcom boom there was a great deal of ‘long term’ investment as investors chased companies which barely produced revenues let alone profits. Some of those investments really did become long term as the market for their shares dried up.
The numbers do matter, but investors also need to be able to trust management. Do they believe a company’s management is credible? Mature investment managers will have memories of being taken for a ride in the past and should have a healthy scepticism: fund managers are critical capitalists. Deeper relationships between investors and companies can come up against regulatory safeguards but reform in this area must look at how this works in practice. The alternative is for fund managers to take the view, based on behavioural finance findings, that meeting company managements at a peripheral level may in fact lead to poorer investment fund performance, as the management story distracts too much from the numbers themselves.
Good management is important. A good management team will get the basics right, from a close attention to cashflow to investment in people. It will focus on sustainable profits growth. A well-run company is usually an ethical company, with an understanding of its responsibilities in society. If the company is to have the privileges of corporate citizenship, it should be exercising citizenship responsibilities too. The Labour government required pension funds to state their environmental, social, and governance (ESG) policies. Pension funds should be clear about how they will put these into effect and how they assess their performance in this area. Government should promote the Stewardship Code and encourage the production of comparable data on fund managers from organisations such as the UN Principles for Responsible Investment, so large institutions cannot hide behind the approach taken by their relatively small ethical funds.
Many funds benchmark against an index, and some funds are very large, which limits the scope for engagement with a company, because the ultimate sanction of selling the shares has gone. That should be counter-balanced by a higher degree of engagement with company management and a higher propensity to vote against directors and propose new faces to company boards.
Reforming executive pay
An area of poor (and short term) incentives which is ripe for reform is executive pay. People read that directors pay has risen 49% and contrast that with their own falling living standards, as inflation makes a mockery of their own salaries. Yet their pension funds are probably voting for those pay increases. Only in exceptional circumstances do most City institutions vote against pay packages. This is despite the vote being only advisory, retrospective, and having no legal power. Investment institutions also continue to vote for the reappointment of directors who are members of remuneration committees which set excessive pay awards. This is a mystery and suggests a lack of market forces. High director pay rises unrelated to performance, or the cost of living, are taking money from shareholders so why they or their agents should be so content with this arrangement is not clear. Of course, even high directors’ salaries represent a small percentage of the profits of most FTSE 100 companies. Furthermore, despite their concerns about pay, investors sometimes become convinced by the star qualities of individual chief executives and so allow them large awards. Yet presumably a CEO who has not ensured the company can survive and prosper without him or her is not such a good business leader after all. The banks meanwhile are in a different dimension; despite the bail-outs and their business models which seem to find new ways to lose money every few years, they continue to pay their executives very high salaries and wonder why the public remains so angry with them.
It is conventional wisdom that pay should be linked to performance and this is a good base level; reasonably stretching performance targets should be set and pay should not appear excessive even if these are hit. Yet CEOs will tell investors they would of course work just as hard for a much lower salary, or a much higher one. We would not want it otherwise. Ask remuneration committee chairs to outline the evidence they use to show that performance-related pay leads to better outcomes for the company and they flee towards generalisations. One would have thought that a bonus structure would be set for an optimal outcome for a company. Perhaps in reality, performance-related pay increases are seen by companies as ‘just rewards’ rather than designed with shareholders in mind. If that is the case, boards have introduced an ethic into pay (if questionably applied) and it is not too big a step to argue that should be applied throughout the company. This is the approach taken by a report commissioned by the Church Investors Group, which applied theological considerations to company pay. A conclusion was that investors should look at pay levels at the bottom as well as the top, and should look at the ratio between the two.
An outline for reform is becoming clear. Remuneration policies should be based on simple and transparent criteria, and should be subject to a binding shareholder vote before they can be implemented. Both companies and investment institutions should be required to state publicly their reasons when backing pay schemes with a ratio between the highest and the lowest ten percent above a certain point. We could even consider whether shareholders should be able to elect a direct representative to remuneration committees.
Power
Reform should be positive in nature. Its aim should be to make the market work for more people and break up the undue accumulation of power. As economic power is dispersed and experienced more widely, so inequality is tackled and there is a better relationship between the City and the society in which it sits. There may be an opportunity to see this if bank lending to SMEs continues to be poor; the City should be able to find alternative mechanisms and in doing so may become more obviously relevant to the wider nation. It could also experiment with different company models. Ultimately, some sort of national investment bank will be required. This is not to downplay the vital international role played by our financial sector; indeed the City can become an innovator in more productive forms of finance. Virtue in markets is important. It matters who runs trading floors, even with a strict compliance regime. Example needs to be set from the top. Yet ultimately virtue cannot be forced; it can only be encouraged and its absence considered a matter for shame. Concentration of power tends to act against virtuous behaviour; that points to the separation of banking activities at the least, for example.
As economies struggle to recover, an important theme will be investment in the future. We can help encourage this by strengthening financial relationships throughout the economy. The City can lead the way by being more proactive in promoting good management, discarding outdated executive pay practices, and experimenting with new forms of finance better related to the ‘real’ economy. Government has an important role to promote transparency, ensure incentives are consistent with these aims, and by standing against any undue concentration of power.
This chapter was in a pamphlet published by PIRC, which can be found here. It explores ideas I discussed in The Credibility Deficit, published by the Fabian Society.
PIRC, 9 November 2011, 13/11/2011