This snapshot, taken on 07/04/2010, shows web content selected for preservation by The National Archives. External links, forms and search boxes may not work in archived websites.
Newsroom & speeches
24 November 2009
It will not have escaped many of your attention that I have been vocal of late about the importance of good governance.
Indeed this is my second speech on the topic for our hosts today in the space of a week!
So whilst I make a small apology to those who may be experiencing a slight feeling of déjà vu at this point, I make no apology for reiterating the point.
Well-run companies are founded on sound governance.
If the global banking crisis has taught us anything, it is that poor decisions were made.
Decisions went unchallenged.
Decisions were allowed to stand.
Good decision-making requires three things.
It requires excellent judgement to identify opportunities and spot emerging risks.
It requires robust governance to ensure that those judgements are in the long-term interest of the company, and to ensure that when judgement fails, there is a back-stop.
And it requires owners to care. It requires shareholders and those who act on behalf of shareholders to take an active role in holding executives to account. It requires their judgement.
The asset management industry is critically placed to lead reform in this area.
You are in the business of managing assets on behalf of others, and accordingly you can set the standards that ensure that the interests of end beneficiaries are fully taken into account in the important decisions that affect them, and that you are clearly and transparently accountable to them.
Recently, I was asked a question about judgement and its role in the financial crisis, and I feel this is where we should start. This fundamental is in danger of being overlooked in our collective response to this crisis, which tends to focus on supervision and the architecture of governance.
This crisis was born of poor decisions; and decisions are ultimately a matter of judgement.
There is no question that overly complex products, a failure to fully appreciate the interconnected nature of some transactions and markets, and a lack of shareholder engagement in firms all contributed to the global banking crisis.
Regulatory responses will rightly require firms to hold more, and better quality, capital and liquidity and will deliver more coordinated international responses to crises.
But ultimately underpinning all the problems we have faced is a failure of judgement; failure of judgement by regulators, central banks and the Boards and senior management of a number of banks.
So how do we address this? How do we ensure that above all else we have firms, regulators and legislators making better judgement calls in the future?
Improved governance is the best mechanism to foster an environment where judgment is better exercised. If delivered effectively, it requires that decisions are made on the basis of sound analysis and evidence.
Good governance ensures that the contrarian voice is heard, the voice that says, ‘maybe this isn’t such a great idea?’ The voice that challenges core assumptions – for instance the availability of wholesale funding or risks to market liquidity – and is willing, if necessary, to do so persistently.
Then once decisions are made it sees that they are documented in a transparent and complete manner.
Such transparency and accountability is of paramount importance.
This is not about having ‘someone to blame’. It allows institutions to learn from their mistakes, building a corporate memory for the benefit of themselves, their shareholders and the wider market.
As Christian Nevell Bovee notes “It is only an error in judgment to make a mistake, but it shows infirmity of character to adhere to it when discovered”. We must not display such infirmity in the crucial months to come.
Governance is the key to good judgement.
This is where shareholders can, and need to be, the drivers of change. Responsibility for ensuring that change happens lies fairly and squarely with the owners of companies – their shareholders. Not with Government. Not with regulators.
In 1990, the Economist compared shareholding to gambling.
The writer said that shares were little more than betting slips, bought at a low price, with the hope that the bet will come good. Shareholders studied the markets much like a gambler might study a form guide, they backed what they hoped would be the winner, then simply sought to extract their ‘winnings’ as quickly as possible.
The author observed that the notion that a shareholder owns part of a company “makes as much sense to a shareholder as it would to the average gambler to imagine that he owns part of Lady Luck, running in the 2.30 tomorrow afternoon” .
Nowhere is this more evident than when fund managers accept the bounce in a share price that comes with a takeover, rather than saying to their clients “we rejected that bid; we know that the share price will fall when the offer lapses, but we take a long-term view and we believe in the company, its strategy and its future. It is always hard to find good companies in which to invest and we don’t intend to sell out of this one simply because an opportunistic bidder appeared. We know that you, our clients, have chosen us to manage your fund for this reason and we know that your interests are focussed on long-term returns rather than a single quarter’s performance”.
I wager that few fund managers feel comfortable in speaking in such a way to their clients.
But shareholders surely should not be gamblers. They are owners. But too many individual shareholders appear with hindsight to have simply been ‘at the races’.
The problem is that most shareholders do not believe that they are owners; they do not feel responsible for the functioning or the future of companies in which they hold shares.
This has profound consequences. The reality of ‘ownerless corporations’ disadvantages public equity as a form of ownership compared with other models – particularly private equity; it leads to pressure for more regulation to offset the vacuum in engaged oversight and it potentially subserviates and alienates employees who cannot diversify employer risk and find themselves working for companies with ‘here today, gone tomorrow’ owners.
The failures of shareholders to act as engaged owners in the past has rightly prompted a regulatory response, particularly for banks, where the consequences of serious failure have such substantial consequences for the economy and for society.
And if collectively we cannot provide adequate comfort that firms will be better run, then this response will have to major on increasing the amount and quality of capital and other financial measures. The pressure to correct for perceived deficiencies in risk management and governance will come from government, regulators and creditors.
The cost will be real in terms of profitability, reducing income for shareholders. Inadequate governance goes to the bottom line.
Demands for more regulation and supervision, more capital and liquidity are, at least in part, a response to shortcomings in governance and public pressure to avoid bad outcomes associated with misjudged risk management and absence of effective oversight by owners.
Most shareholders transfer the responsibility for ownership to fund managers or institutional investors.
But it is up to owners to express their interests in the long-term health of the companies in which they have invested, and their attitude to the long-term versus the short-term and to then ensure that these preferences are clearly understood and accepted by their fund managers.
Institutional investors have the power to act and intervene as responsible owners. But most have been reluctant to step up to the mark.
They argue, I think correctly, that their clients show little interest in the concept of investment as ownership, and that that a strong focus on relatively short-term performance reinforces this view.
Accordingly, few fund managers take corporate governance seriously – leaving it in the hands of junior employees, with little or no experience in the real world of business.
No-one wants ownerless corporations, run by managers for their own short-term gain. But seemingly, no-one wants to ‘do governance’; they are content to free-ride on the efforts of others to hold Boards to account.
This is nothing new – back in 1990 Rupert Pennant Rea said “What is wrong with the British and American system is that far too many shareholders, both institutional and individual, do not behave like owners”. Put simply, there is an ‘agency gap’.
The Government has had to take action to step in to a situation in which theory would have suggested – and Alan Greenspan expected – enlightened self-interest would have driven the right outcomes.
Shareholders did not, and should not, have had to wait for Government to take the lead on driving better and more meaningful disclosure of remuneration, or risk management.
Collectively, owners had the power to press for such reforms. But they didn’t.
To the extent that these problems constitute a market failure, the Government has a responsibility to act, and has already done so.
Sir David Walker’s review and recommendations on governance in the banking sector will report on Thursday. Sir David has rightly focussed on investor stewardship and governance processes within corporations.
His interim report has recommended far-reaching changes to strengthen board challenge and shareholder oversight and improve the quality and independence of risk management.
Beneficial investors, pensions funds and insurers should support Walker. He is working for their benefit.
In parallel, the FRC is reviewing the Combined Code and considering which of Walker’s preliminary recommendations might have wider applications beyond the banking sector.
The FSA is implementing remuneration principles, which will ensure that banking remuneration practices will never again contribute in the way they did to excessive and unmanaged risk.
The Government will ensure that shareholders have the information necessary to fulfil their duties in challenging boards about risk appetites and management, and the alignment of risk with remuneration.
Excessive or poorly designed remuneration did not cause the financial crisis, but it did play a role in that the asymmetry of risk and reward was more favourable for the investment banker or trader than the shareholder. The table appeared tilted in favour of the executives. Shareholders were disinterested in restoring the balance.
In many investment banks, where the split of revenue between company and trader went unchallenged, the supplier of capital - the ultimate risk-taker and franchise owner - was potentially under-rewarded.
Conventions have been established in investment banking and the casino parts of banks about revenue and profit splits which have largely gone unchallenged by boards and shareholders. The weak and the lazy have found it easier to accept crude formulae for splitting the distribution of surplus rather than exercise judgement.
In the current climate, the priority for banks should be to rebuild share capital. Current profitability, itself a product to a considerable extent of benign conditions, rather than skill or talent, provides that opportunity.
I take on board the obstacles to investment managers adopting a governance centric approach.
I realise that there will always be an incentive to free ride on the governance efforts of others and that the relative invisibility of governance-driven returns can make it hard to justify the necessary expense.
But, in light of the recent financial turmoil and the sheer quantum of value destroyed by governance shortcomings, I think it is fair to ask all participants in the investment chain to act in any way possible to prevent history repeating itself.
We have seen poor governance and ineffective stewardship play a part in causing significant loss of value.
Weak governance incurs a real cost in terms of lost value. This potential cost becomes even more significant if we are moving, as I expect, to a period of low portfolio returns.
I am often told by prominent asset managers that when I call upon them to take their governance more seriously, I fail to recognise that at the end of the day this is all a question of client preferences.
Most clients do not demand active governance so what business is it of any asset manager to spend their money doing it?
I find this argument too defeatist. Of course any business needs to focus on doing what its clients want, but the best businesses do not take that as a reason simply to follow market trends; they try to create an innovative and distinctive offering. They set out to lead the thinking of their clients.
I would like to see more fund managers prepared to go out and sell their ability to add value through governance.
And I would like clients, trustees and others to be more inquisitive about the potential for governance to add value; more penetrating in asking about what their current managers do in this area; and less tolerant of mumbled replies and shrugged shoulders.
The investor case for active governance seems to me to be at least as strong as the investor case for active stockpicking, and I see no shortage of billboards proclaiming managers' prowess in that latter area.
So if firms in this industry are prepared to try to differentiate themselves on the quality of their stockpicking, why not make good governance a selling point?
At least in the governance case we are not talking about a zero-sum game; the net global supply of alpha is zero, but if strong investor engagement leads to better corporate performance overall, it increases the size of the pie and not just the share of it which goes to the best managers.
In my view governance is not just a corporate afterthought, but is the means by which stable revenues and value creation are built into future revenues.
Mark Goyder of Tomorrow’s Company talks about the parallels of stewardship in business and in football.
He called for business to act like those football clubs which take “a long-term view who see beyond wheeling and dealing, clubs which focus on management continuity, youth development, improved facilities, and the club giving something back to the community it comes from.”
As I see it, bringing about the necessary change will require a cultural shift in the way governance is considered, an industry restructuring effort that puts governance for many, at the heart of investment decisions. I am not suggesting that all fund managers should ‘do governance’ but I have no doubt that it would be in the interests of their clients and the economy if more did so.
From an operational perspective, individual firms who rise to the challenge will need to develop the systems and capabilities necessary to facilitate continuous and effective engagement with both capital providers and corporate managers in investee companies.
Oversight and engagement systems need to feature in the industry standard business model. They need to become part of the corporate furniture; immediately familiar to employees at all levels and in all functions.
It will only be as a result of such an industry wide effort that we will be able to ensure the interests of investors feature in every decision made, drive effective board performance and flow through to the corporate strategies deployed in investee companies.
At a wider level, the investment community needs to take seriously the case for an organisation to promote and further the debate on governance and stewardship.
A number of trade associations – the ABI, IMA, NAPF and others – have devoted resources to governance, but their primary role is to further the interest of their members; they mostly speak for the agents rather than investor principals.
A strong, well-resourced body speaking solely on behalf of investors (the ultimate clients) would represent a valuable addition to the forces working for better governance and stewardship.
I have called before on the fund management industry to endorse and fund such a body, possibly in partnership with a major business school (and endorse it without strings attached).
This would, I believe, demonstrate a recognition that good governance is critical to the long-term viability of the public model of ownership and a very evident commitment by professional suppliers of investment management services and products to promote a better and more accountable stewardship.
Without significant steps forward, the ‘ownerless corporations’ will sleep-walk in to another financial catastrophe.
The time for stewardship is now.
Mark Goyder puts it simply. Stewardship means “looking after assets for the long term, and being more aware of what is being done in your name – whether the money is going into debt or equity – and having the assurance that those who handle that money are doing so in a principled way.”
It means owning up to ownership.
Thank you.
