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Newsroom & speeches
30 June 2009
Check against delivery
Good afternoon and thank you very much for inviting me to join you today.
Let me begin today from a moral perspective and begin by speaking to the position that banking occupies in our economy and society and the duties and obligations that come with this.
Banks have a special place in the economy because of their central role in the allocation of resources. The banking sector is different from other industries in two respects: it depends on promises to repay, and so is uniquely vulnerable to changes in confidence, and the repercussions of bank failure on individuals and businesses can be severe. These two factors combined mean that when banks or banking are in difficulty, or possibly even perceived to be in difficulty, society has to step in.
But implicit or explicit state support can give rise to moral hazard –self- interested financiers will respond to this support by taking on more risk, or under-price risk knowing that someone else will pay the bill if all goes wrong.
We can mitigate some of these incentives through regulation - but an efficient system can never rely on regulation alone. Good corporate governance and stewardship are key.
With implicit and explicit guarantees come moral duties, and obligations to behave in a manner consistent with the good of society.
Since the start of the crisis the Government has taken significant action in supporting the banking system. We - and the taxpayer- expect a lot in return.
Some of the support measures come with specific contractual obligations about lending. But beyond their legal obligations, banks also have moral duties.
In return for the privilege and protection afforded to them, banks have special responsibilities - to individuals, to business, to the wider economy. They must act prudently and conduct themselves in a way that is beneficial to society. Pursuit of profit must be tempered by self-restraint mindful of the social and economic consequences of making decisions which individually might be optimal but when aggregated with other similar decisions can cause unbearable economic strain and social harm. This is why we have insisted on banks taking an enlightened approach to helping and supporting customers rather than casting them adrift. Banks and their boards will not be forgiven for biting the hand that has fed them during their hour of need.
Society will not accept behaviour from banks which appears self-serving, hubristic, or driven by excess and greed.
All British banks have benefited from support by the State in the sense that they have profited from the greater stability brought to the system.
Banks must now evidence to society that they intend to eschew the poor risk practices of the past and re-establish a reputation for responsibility and probity. They should rise to the challenge- as indeed some already are - of working positively with initiatives such as the Saving Gateway and the Dormant Accounts Scheme, and take seriously their role in delivering financial inclusion and financial capability.
Society would rightly be shocked if banks paid large bonuses to senior executives while cutting back on community support programmes or neglecting their commitments to support affordable credit in areas of highest financial exclusion. The actions of banks in these areas will be critical in rebuilding trust in the financial system.
Lending, and, importantly, lending that is reasonably priced, is essential to economic recovery. The Government has taken steps to stabilise financial markets and support lending to the economy, with a particular focus on home finance for individuals, and lending for small and medium-sized businesses. As part of this, we have negotiated specific lending agreements with banks accessing Government support schemes. We are working to support a return of confidence and, in this connection, expect lenders to maintain the appropriate provision of credit, and provide a fair deal for individuals and businesses that need their support.
At the end of last year, the Chancellor established the Lending panel, bringing together the Government, the FSA, Bank of England and industry in order to monitor lending to households and business and to drive up standards in the market. As part of this new approach, the Bank of England publishes a new monthly “Trends in Lending” report.
In support of this new more engaged approach, three new groups, the home finance forum, small business finance forum and consumer finance forum were also established, reporting to the lending panel.
I chair the home finance forum, bringing together Government, lenders, agents, trade associations, consumer groups, and regulators on a monthly basis.
We are developing our understanding of markets through the Lending panel and other groups, identifying areas of concern, and, where necessary, taking action. Building up a detailed picture of market trends at a time of sustained and dynamic change represents a significant advance in positive engagement between the banking industry and Government, and is likely to have continuing utility beyond the crisis that led to the creation of these fora.
I said earlier that I would talk about regulation and supervision. It is important to stress that regulation cannot be the sole load bearing instrument in ensuring that our financial system is sound and able to fulfil its role in the wider economy. The greater component of strain has to be taken by governance and investor stewardship. Good companies with credible strategies and effective boards do not fail as a result of regulatory shortcomings. Financial Services regulation does not exist to protect shareholders; shareholders must take front-line responsibility for the companies in whose equity they have invested their client funds.
It is clear that corporate governance failures materially contributed to the financial crisis. The OECD’s assessment is stark: weaknesses in remuneration, risk management, board practice and the exercise of shareholder rights resulted in excessive risk taking. These issues must be addressed. The UK is a thought leader in addressing such issues: through the FSA’s work on remuneration and director quality; through Sir David Walker’s review of the governance of financial institutions; and with the FRC’s current review of the Combined Code.
But I believe that our journey of reflection needs to take us to a deeper level than previous expeditions under the captaincy of Cadbury and Higgs etc. In particular, many of the tenets of modern portfolio theory and the presumed strong version of the efficient markets hypothesis deserve to be questioned.
Most practitioners were well aware of momentum effect long before Chuck Prince came up with the perfect metaphor. This momentum (or herding) was evident in the behaviour of both banks and their major shareholders, the institutional investors. Paul Woolley from GMO has funded academic research that demonstrates that markets can diverge from ‘fair value’ for sustained periods. Markets are prone to excess- driven to move outside ‘fair value’ by fear and greed and, importantly, the behaviour of other investors.
The concept of fair value, and the market forces that take market value away from fair value, be it in proprety, housing or securities, is going to become an increasingly important one as we discuss and develop mechanisms for macro-prudential intervention. It seems to me that in the securities markets peer group pressure, momentum investing (overt or covert) and benchmark selection will all come under greater scrutiny as we ask whether market value necessarily equates with fair value and what, if anything, can or should be done by the macro-prudential agents to engineer a return to a more sustainable and supportable range of fair value. Today’s focus on absolute performance has dulled our sense of absolute value. Investors (and bankers) have every incentive to “stay in for the ride”, even when market values have deviated markedly from fair value.
Questioning aspects of the efficient markets hypothesis (at least in its strong form) leads us to ask what it has to say about measuring value and performance. “Shareholder value” has become the guiding light for evaluating corporate performance and investment success and for rewarding executives. Institutional investors have foisted on companies the same short-term benchmarks used by their clients to evaluate them, without adequate discussion on whether this leads to optimal outcomes.
Shareholder value is now largely defined in terms of the movement of the share price or TSR between two points in time. It tends to be measured over elapsed time periods which are very short in the context of both the likely lifetime of a company and the nature of the liabilities that investment assets are frequently designed to match. This is odd.
Indeed, if we pause for a moment, we see it is more than odd – it is nonsensical. Share prices are normally taken as the last trading price before close of business at the end of dealing on the day of valuation – today being a particularly important day, as it is the end of the half year. But markets can be thin and volumes are most unlikely to reflect the size of the holding a fund manager may have for multiple clients in a single security. These prices are at best a rough and ready indicator of value, but we have placed upon them burdens of great significance. TSR is used as the baseline for evaluating fund managers and, thereby, determining their behaviours, and TSR also lies at the heart of many executive remuneration programmes. If market value is not necessarily fair value we may have placed too much reliance on it.
If we challenge the objectiveness of markets in finding ‘fair value’ and expose the very approximate date that lies at the heart of TSR and portfolio performance calculations we create an opportunity for a more enlightened debate that might take us towards a better understanding of shareholder value. But this will not happen while focus for institutional investors is on outperforming competitors and indices over short time periods. This approach, quite rationally, has lead most core fund managers to create portfolios that are highly diversified and lacking in stock specific conviction; going with the crowd; not dissenting form the consensus (as we saw with the dot.com bubble); subordinating ‘fair value’ to second guessing. Such an approach has a profound bias over time to extremes of under or over valuation. That is why no major institutional shareholder stood up to challenge the increased leverage building up in the banking sector; no major institution seriously questioned hubristic take-overs; no one told Chuck Prince to “sit out the next few dances”; few challenged the wisdom of putting companies under pressure to ‘optimise balance sheet efficiency’ by taking on more debt or risk falling in to the hands of bank-financed private equity. No one spoke up for the end client, the pension scheme member or funder. No one exposed the nonsense of extreme behaviour and extreme valuation.
This line of thinking takes me towards asking whether we need to develop complimentary mechanisms to support value measures in executive compensation. The insidious influence of benefit consultants (fixated on external comparators with little or no regard for relativities within the client company- a community Warren Buffett has described as ‘Ratchet, Ratchet and Ratchet’ ) has played into the hands of the weak and lazy on remuneration committees who prefer to have the computer tell them the answer rather than exercise judgement, save that, unlike the computer of Carol Beer, the character in “Little Britain”, this computer tends to say “Yes”. Institutional investors have contributed to this with their own preference for schemes which closely mirror their own objectives, regardless of how detached this might be from incentivising the creation of sustainable long term value.
The issue of executive remuneration has a particular salience for banks because of the direct and indirect support the sector has received from taxpayers. Banks now owe it to society to be open in their disclosures about the criteria which drive their compensation policies and the culture they are seeking to promote. Taxpayers will not easily be convinced that it is either right or necessary to pay large bonuses to people employed in an industry that has required so much support from public funds. The onus is now on remuneration committees to be explicit about why senior executives are paid the way they are, and we need to see this explained in the context of overall compensation within the company.
In response to the failures exposed by the financial crisis, thoughtful remuneration committees will be developing a new type of remuneration approach that takes account of the limitations of shareholder value that I have outlined. Their approach will focus on longer-term value and, importantly, take account of risk .
Given that the executive compensation schemes cannot be symmetrical – they cannot impose negative consequences on the executive equivalent to the positive outcomes –a simplistic shareholder value approach provides a perverse incentive for executives to increase stock beta if returns are not risk-adjusted. Simple schemes encourage executives to push the risk envelope. This contributed significantly towards excessive risk taking and pro cyclicality in markets. Boards and their independent directors are there to exercise judgement. Are increased returns a good reward for a possible increase in business risk or are they no more than a pound for pound reflection of increased risk that has been taken? Boards and shareholders need to be alert to, and manage appropriately, an executive disposition to increase risk. This is a core and important requirement of effective corporate governance, particularly in banking, because of the social and political consequences of banks being induced to take on too much risk. Market value is still probably the core to measuring corporate success (after all, valuation should account for change in risk if this change is evident) but in future we are likely to see it moderated by other factors that rely on judgement (although this in turn depends on the reliance we can place on those making the judgements – primarily independent directors)
Finally, let me say a few words about some of the significant regulatory changes that are already underway at international, European and at national level.
Taking the latter first- next week the Treasury publishes it paper on the future of financial services regulation and supervision.
There have been calls from some for a fundamental change in the way regulation and supervision are carried out in the UK.
No one model or approach to regulation and supervision has emerged from this crisis without some shortcomings being highlighted. There is no simple solution; no obvious answer. That is why we need to have an open and honest debate about the shortcomings of the past and the new challenges we face.
But the process of responding to the crisis by strengthening our regulatory system has already begun. We have introduced powers in this year's Banking Act that mean we are much better prepared to deal with the failure of financial firms. But given the significance of the changes in global financial markets we will need to look at giving both the FSA and the Bank of England additional responsibilities and powers.
We also need to look at the way we work together because it is crucial that we see good co-operation and good collaboration - both between institutions here at home and across borders.
In the UK, since the credit crunch began two years ago the Bank, the FSA, and the Treasury have been working together very closely at all levels. And that cooperation continues as the Treasury prepares to publish our proposals next week.
Having seen the Tripartite from the inside I can work that it works with a very high degree of cooperation and collaboration at both working and senior levels.
The Treasury's key interest in the reform process is to look at how we can strengthen the system - here and internationally - to provide better protection for our economy.
My hope - and I know it's the hope of the Bank and the FSA too - is that the debate will focus on the substance of reform.
This is the domestic element- but of course, [as Lord Mandelson said yesterday], the other key force in determining how UK firms and markets are regulated and supervised is the European Union.
In its conclusions published on 19 June, the European Council set out a number of decisions intended to lead to the creation of a new financial supervisory architecture with the aim of protecting the European financial system from future risks and ensuring that the mistakes of the past will not be repeated.
I welcome the European Council conclusions, which provide us with a clear direction and framework for the legislative negotiations. They were outcomes that were good for Europe and good for Britain.
Two points particularly important to the UK and on which we secured agreement are:
First, we agree that it is important that we establish within the EU a macro-prudential early warning system to identify risks in the financial system. It needs to be independent and to represent the whole of the EU, and so should not always be chaired by the President of the ECB. It should include both central banks and national supervisors, who will bring their own invaluable technical expertise to help inform the body’s analysis. I therefore welcome EU leaders’ agreement to this.
Second, I believe very strongly that supervision should continue to be undertaken at the national level, and welcome the emergence of consensus here. Supervision and the arrangements for fiscal support to individual financial institutions in times of crisis have to be aligned. Only governments can provide that support. Supervisors must therefore be accountable directly to them. Supervision is also likely to be far more effective where it is close to markets and firms.
I am pleased to see Council’s agreement to restrict binding mediation to supervisory cooperation, the implementation of rules and disagreements between home and host supervisors. The latter will help with an important single market issue, where we have seen that there are currently insufficient safeguards for cross-border branches.
But, as always, the devil is in the detail. Also, and here I quote my colleague Lord Mandelson, the UK ‘has more skin in the game than the rest of Europe put together’.
So I reiterate that the Chancellor and I, and other members of the Treasury ministerial team, will fully engage with other Member States and the European institutions to make sure the forthcoming legislation delivers the right outcomes for us. I have also taken a particular personal interest in the Alternative Investment Fund Management Directive.
Finally, on the international front, I believe that the objectives of convergence and consistency will be essential to the reform of global financial regulation – a point reinforced by the Washington and London Summits.
In the lead up to international meetings in the autumn to assess the progress made, the UK and its international partners must work closely together to deliver the commitments made on improving financial regulation- and providing better outcomes for all
The UK will be playing a leading role in driving for effective international action.
Ends
