Long-term Matters: Learning from bailouts
Why do bankers still not get their part in, to use Ken Rogoff's phrase, the ‘Great Recession'? And what have institutional investors learned from these bailouts? An interesting CFA Institute blog shows that bailouts today are more frequent and more destructive than ever before. Unsurprisingly, the ‘why' is deeply contested. Here's my diagnosis to balance orthodoxy.
As with other ‘preventable surprises', banking bailouts are characterised by six drivers: regulatory capture, disregard for negative externalities, narrow definitions of risk, leadership/governance failures and organisational learning disabilities. The sixth factor is what investors contribute, namely shareholder value fundamentalism: it is the catalyst that makes this cocktail really toxic. Worryingly, all six are still active today.
Wall Street's takeover of political and regulatory activity is well documented. The net result of reforms is that ‘too big to fail' banks are now even bigger.
Negative externalities continue to get inadequate serious attention. As FT journalist Gillian Tett describes, decision-makers have conveniently avoided coming to conclusions about the 2010 ‘flash crash' yet most independent commentators point the finger at high frequency trading.
Financial houses have strengthened their risk teams but there's been little thinking beyond the discredited VaR approach. Conflating risk with uncertainty, such reductionist models give falsely reassuring answers (UBS). And when risk officers do step up to the challenge, complicit boards look away when over-dominant CEOs ‘kill the messenger' (MF Global).
The biggest leadership/governance failure is denialism over pay, notably in stimulating excessive risk taking and so exacerbating systemic risk as Bank of England's Andy Haldane describes so well. This lack of action on pay is clear proof that weak governance remains the norm. And academics are also now showing that exec pay levels are holding back recovery.
Acting as enablers for all of this are institutional investors because of our ideological fundamentalism, in other words, "shareholder value maximisation".
Of course, it need not be thus. So here are some questions to prompt critical reflection. The good news is they are based on what some mainstream investors are doing already.
When its performance is so weak and undisclosed risks so high, why is (high) benchmark exposure to the financial sector so common? Sector allocations based on cap-weighted indices don't come from God. Technical improvements (eg, fundamental indices) are quite easy. Nouriel Roubini even suggests pension funds divest until banks become more responsible.
Why isn't more being done on pay? There has been no real change to metrics or incentive design. Indeed, the average longest performance period to trigger incentive pay of CEOs of the 15 largest US banks is two-and-a-half years.
Of course, it's not just investors who are complicit, so too are regulators: no senior banker has ended up in jail in any country.
But perhaps most important, why are asset owners as mute in major policy debates today as they were before 2008? The bankers do not make the same mistake. Actually, it is even worse. The one case where asset owners have taken a high-profile public position has been against the financial transaction tax. And these long-horizon diversified owners are using arguments which differ only marginally from banks that lobby to protect their trading functions and deliver the ‘number'.
Where's this heading? According to the director of the prestigious Max Planck Institute, now that markets rule everything, democracy is at risk: "There seems a real possibility of a new, if temporary, settlement of social conflict in advanced capitalism - this time entirely in favour of the propertied classes now firmly entrenched in their politically unassailable stronghold, the international financial industry." Perhaps we'll be lucky and avoid this dystopian outcome. But we're already seeing big drops in human well-being and economic productivity. And the energy (and cash) to deal with major threats to global stability like climate change has fallen significantly.
It is ironic that pension funds and insurance companies, who aggregate the wealth of the ‘little people', are also the enablers of this ‘preventable surprise'.
Raj Thamotheram is an independent strategic adviser, co-founder of PreventableSurprises.com and president of the Network for Sustainable Financial Markets