David questions experts on short-termism in financial services

Tuesday, 22 May, 2012

The Treasury Select Committee (TSC) is investigating corporate governance and remuneration in the financial services sector.

As part of this the TSC has taken evidence from the following expert witnesses: Baroness Hogg, Chairman, Financial Reporting Council; Peter Montagnon, Senior Investment Advisor, Financial Reporting Council; and Sir David Walker, Senior Advisor of Morgan Stanley.

David Ruffley MP questioned the experts on what could be done about short-termism among executives and investors. The full transcript of the exchange is below:

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.