The Crisis: the role of investors
11 March 2009
Speech by Hector Sants, Chief Executive, FSA
NAPF Investment Conference 2009
Good afternoon, may I thank you for inviting me here today. It has given me the opportunity to combine with one of my regular trips to our thriving office here in Edinburgh.
As owners of UK companies, you have a significant role to play in these difficult times. As investors in a significant proportion of UK equities you have the opportunity to exercise indirect and often direct control and influence over the UK economy and thus, as I am sure you will agree, you have a major role in addressing the issues arising from this financial crisis.
The focus of my remarks today is how we can ensure this influence is as effective as possible. I have, as you know in the past, questioned whether investors have in all cases truly understood the products they were buying and if there had been more effective and collective shareholder intervention whether the financial crisis we are witnessing would have been as severe. These are issues I would like to explore in more detail today.
I am not going to spend time analysing in any depth the causes of the financial crisis; I commend our Chairman’s recent Economist lecture which does provide a detailed analysis. I would, as I have said, like to look forward and in particular discuss from a regulators perspective how we, and you as market participants, can learn the lessons from these events.
However, before doing so, I think a summary of how we arrived here will be helpful. In my view there were seven fundamental structural failures that have led to this crisis:
- A set of macro economic conditions such as global imbalances and low interest rates;
- A prevailing mindset of Government and society promoting the benefits of credit and asset inflation, notably in housing;
- A flawed global regulatory architecture which in particular lacked adequate macro prudential oversight and had a series of gaps with regard to the oversight of financial institutions, particularly shadow banks, such as SIVs.
- A flawed set of prudential rules particularly for capital and liquidity. Basel II is an improvement on Basel I but still has large elements of procyclicality.
- A failure of the market to self-correct. A failure to recognise the overriding influence of the herd instinct;
- A pro-cyclical interaction between the accounting regime and market sentiment; and
- A lack of responsible governance by market participants, in particular bank management themselves.
These circumstances then led to a series of proximate drivers which led to the crisis of which I would highlight three: a significant increase in leverage; too great a dependency by the market on securitisation and short-term wholesale funding; a search for yield and excessive risk. A further defining feature of this crisis has been that these failures within financial markets, when seen through the lens of the media and individuals have, at times, led to a negative feedback loop with public reaction often exacerbating the problems of individual firms and increasing financial instability.
Our Chairman has been charged by the Chancellor to conduct a full review of these events and to bring forward proposals for change. His views will be published alongside a full Discussion Paper setting out our more detailed suggestions on 18 March. It will also describe changes to the FSA’s regulatory philosophy. The FSA has been open in acknowledging its share of responsibility for the failures we are seeing in this financial crisis, in particular in relation to firm specific regulation. We highlighted the lessons we have learnt in relation to our supervision 18 months ago and we are well down the track to delivering the required changes. However, undoubtedly, the FSA alone would not have been able to prevent the financial crisis that has unfolded, even with a different approach to supervision and what is clear is that change is required from all market participants. We are thus advocating change across the whole financial community both domestically and globally.
It is important to recognise that regardless of the improvements the FSA makes there are limits to what regulation can achieve. All regulatory judgements carry risks and, in particular, judgements on the future will necessarily not always be correct with hindsight. Regulators make no claim to be infallible. Indeed it is essential that firms do take risks, for without risks there will be no innovation or competition which are the basis for economic prosperity.
Given this view it remains fundamental that we recognise that firms’ senior management carry primary responsibility for their actions and their resulting consequences. This responsibility is also shared with non-executives, shareholders and auditors. The FSA believes strongly that a key element of successful regulation is to work in partnership with these groups. The recent market events support the view that non-executives, in particular, must play a greater role in the oversight of executive management. I think the same can be said of institutional investors.
Today, as I mentioned, I would like to focus on how investors, in particular, might respond to these significant events. First, a mention of some of the historic presumptions behind investor behaviour. At the risk of over-simplifying, it could be argued that institutional behaviours have been driven by two principal beliefs.
Firstly that market discipline will ultimately address excesses. In practice this discipline has not been apparent in the recent financial crisis and, if anything, market behaviours have been pro-cyclical. In future both regulators and investors will have to recognise this fact and adjust accordingly. Inherent in this for us both will be a need to intervene earlier, which in itself implies acting both on expectations of future events as well as focusing solely on historical data.
The second and traditional belief has been that while shareholders have responsibility as owners, given their primary responsibility is to their clients; ultimately if they are dissatisfied with a company their primary response is to sell the shares rather than to press for changes. It is undoubtedly the case that their primary responsibility is to their clients but I am sure you will agree that it is in everyone’s collective interests that good governance is maintained, at least in large companies, and as a result financial stability is maintained.
Against this backdrop I would now like to make some observations as to how investors could react to the crisis for the benefit of the longer term. As is always the case some of you may well maintain you are doing much of this but I believe in aggregate there is more that we all can do. I would like to address my comments under your two roles. Your role as owners and your role as investors.
As owners we would encourage you to focus on four issues: governance, risk management, business strategy and the issue of compensation. To do that however, you clearly both have to engage more actively with senior management and Non Executive Directors but also arguably organise yourselves more effectively for collective action.
On governance, Sir David Walker has been commissioned by Government to produce a report. The FSA will be working with him to develop proposals to address these issues. What is, in my view, already clear is that there must be greater oversight and you as owners of the business must be active in the risk management process. The impact of companies lacking robust risk management and good governance will, as we have seen, impact negatively on your long term investment performance. A lesson for you from this crisis must be that greater interrogation of how well a company is managed and the adequacy of its risk controls are all material factors fundamental to investment management. A focus of a firms risk control framework must be an effective risk and audit committee and knowledgeable non-executives with a willingness to challenge senior management. Investors must play a role in ensuring such a framework is in place and effective.
Shareholders must also take responsibility to be active individually and more importantly, in collaboration with other investors, to engage with senior management and Non-Executive Directors in companies and question the effectiveness of the construct of their boards. The FSA is keen to encourage greater dialogue between the regulator and investors and we would certainly like to hear when any issues or risks you raise are not being addressed.
On business strategy, I highlight the issue because many of the failures in the last 18 months can be traced back to poor strategies and business models. The responsibility for ensuring effective delivery in this area is primarily for management, but as investors you should challenge management to ensure their plans are credible. A phrase I have used before comes to the fore: “boards should understand the circumstances under which their firms will fail and be satisfied with the level of risk mitigation”.
There are also specific questions around how institutional investors voice concerns and exercise their rights through voting; particularly where there are concerns about business strategy and also management or performance. Once an issue has reached the stage of a public vote, often the stakes are too high to vote down. We would like to see earlier intervention.
Finally, can I address the issue of ensuring remuneration policies are consistent with effective risk management. The FSA has set out a framework, subject to formal consultation, to ensure firms have policies in place which are consistent with sound risk management and which do not expose them to excessive risk. We will rigorously pursue this agenda but to be truly effective in bringing about change, this must be in partnership with you; particularly as unlike ourselves you should be focused on the quantum of remuneration as well as the structure. Historically, your influence has only been wielded at board level; it must now extend to the organisation as a whole.
Turning to you as investors, the question I would like to focus on is whether you all knew and understood what you were buying. The crisis has arguably been driven among investors by an intense search for yield; a desire to gain as much as possible at a ‘risk free rate’. These imbalances stimulated demand which has been met by a wave of financial innovation in the form of complex securitisation. How many of these different ways to satisfy demand and “add value”, by offering investors more combinations of risk and return more attractive than those available historically, were truly understood?
Many of you are also too reliant and unchallenging of ‘normal channels of information’ for example annual reports and company announcements. In parallel to regulators taking a more ‘macro-prudential’ view, long term investors must assess all risks to a business and be challenging of the information offered by a company, and perhaps more importantly, interrogate that which is made freely available. Companies have become all too good at ‘framing’ the information presented to us i.e. focusing on the information of the companies’ choosing. Likewise, some investment management models rely on company reported information. It is difficult to see how we can be truly objective in these circumstances.
Similarly, there appears to be an over reliance on credit rating agencies, external advice and a willingness to accept the views presented. These are often geared around quarterly reporting cycles and do not, therefore, encourage investors to make a more long term assessment. This issue is exacerbated by the so called ‘free-rider’ problem in that an investor who has engaged earlier than others bears a greater cost of their actions. Other investors tend then to be less inclined to engage or the ‘herd’ mentality comes into play with little challenge of others views. All these remarks illustrate the simple point of ensuring you should not buy what you do not understand.
In closing I would summarise my theme today under four headings:
The causes of this crisis are undoubtedly diverse and global – and local supervisory failings, although a relevant factor, were not the principal cause.
Reform is needed to the global regulatory structure but it is important to understand the limits of regulation. Regulators make no claim to be infallible.
It is critical to recognise that the principal responsibility for managing firms responsibly remains with the management of the firms and that shareholders are the principal mechanism for holding these managers accountable.
Shareholders going forward, have a duty, an obligation to make that oversight role more effective.
In order to discharge this obligation you not only have to be more focussed and engaged in individual institutions but also you need to give careful consideration to how you more effectively achieve collective action.
I hope you find these remarks thought provoking and useful. The FSA looks forward to working with you both as individuals and with the NAPF to develop these themes. To this last point can I just emphasise the importance we attach to effective trade representation and the value of collective action and confirm the willingness of the FSA to support you in developing responses to these key issues.
May I thank you for your attention. I am happy to take questions.