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«Restoring Trust in Financial Markets. A. Introduction The task, we are told, is to restore trust in financial markets after the damage done by Enron ...»

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Restoring Trust in Financial Markets.

A. Introduction

The task, we are told, is to restore trust in financial markets after the

damage done by Enron and its cohorts, the “tech bubble”, and earlier by

the Asian crisis. Confucius said that a ruler needs three things – weapons,

food, and trust; if he has to give up any of these, weapons go first, then

food. “Without trust we cannot stand”. (quoted in O’Neil 2002). But how

do we strengthen trust? We are now in the phase of the economic cycle when we hear increasingly-strident cries that “the government ought to do something about it”. So there will be pressures to re-write, formalise, strengthen and centralise the rules of prudential supervision, governance and corporate behaviour, making them more intrusive and prescriptive.

Of course formal legally-enforceable rules and regulation are part of the environment which provides incentives for good corporate behaviour. But

there are two broad constraints on what can be done with formal rules:

- They are costly to administer and introduce distortions – “the law of unintended consequences”

- The more comprehensive the rules are, the more the rule-makers will be blamed when things go wrong, as they will.

Governance is about behaviour, which stems from a wider system of incentives than simply those set down in the formal rules. We need to put maximum reliance on market discipline, and making markets work better may pay higher dividends than overly-refined governance rules, or lumbering directors with new (and often unattainable) responsibilities.

“Restoring trust in markets” may be the wrong starting-point: maybe people have had too much trust in the efficiency of markets, and in the universal presence of honest and competent managers (recall Warren Buffett’s advice: “only invest in companies that can be run by a fool, because one day they will be”). What we should restore is reality, caution and scepticism. By all means we should endeavour to improve company governance, but what also needs to change is the public’s perception of how much (and how little) the formal legally-enforceable rules of good governance can deliver, to encourage them to make their own decisions about who to trust and who to shun.

In this paper, I argue that business has become more complex, and so the problems of corporate governance have become more difficult. There may be a need for new legally-enforceable rules (or a re-jigging of the old ones), but we should be looking elsewhere for less formal rules and norms of behaviour, and for ways of making self-regulation work better than it has in the past. We should also harness the power of market discipline, but this means we should also look at ways of making markets work better. Then, having done what we can to improve the rules and to use markets in order to reinforce incentives for good governance, we need to remind investors that they are responsible for their decisions, both good and bad.

Changes in Market Behaviour The problems that give rise to the calls for more government action may be getting worse, for a variety of reasons. First, the “culture” of business may be changing. Whatever it faults, the elitist and patrician culture associated with the traditional business clubs did carry with it a set of codes of behaviour which, while not always honoured, provided an element of nobless oblige and some constraints on behaviour. This has been replaced by a more amoral and sharp-edged shareholder value mind-set. For many businesses, the notion of “stakeholder” and “shareholder” are synonymous. Questionable behaviour has, on occasion, been justified in terms of a narrow and short-term view of maximising shareholder value.

At the same time, as financial markets get more efficient, they probably become more volatile. Short-termism by managers is encouraged by continuous reporting and the configuration of salary incentives. More efficient markets may be riskier markets. Many of the sophisticated “financial engineering” products are just ways of unloading risk to the ignorant. Derivatives are claimed to shift risk to those who can bear it, but there is little evidence of this – e.g. banks shift credit risk to insurance companies, but there are no indications that insurance companies are either more able to assess credit risk or more able to withstand misassessments. Securitisation takes the safest assets off the balance sheets of traditional core financial institutions – the safe and conservative managers. Now, credit securitisation means no-one is on credit watch.

Information technology means that all market players have instant access to the same market-shifting news, and this tends to trigger discontinuous (“jerky”) shifts in market sentiment, through correlated expectations.

Globalisation reduces the detailed knowledge of investments and encourages herding, so even the most diligent funds manager will be caught when the herd turns.

Meanwhile, the fat and slack which provided some cushioning of volatility in the past has gone. Prudential regulators used to talk approvingly about “healthy profits” in the banking sector, which the economists took as proof of inefficient “excess profits/rents”. As these rents disappear, the system becomes more efficient but also more fragile.

The future probably won’t have a bull market to hide the mistakes and the fluctuations in returns: the abnormally high tide lifted all boats. The two decades of fabulous returns now leave a legacy of unrealistic expectations, which some companies will promise to meet (and will disappoint investors), while others will try to repeat the high returns through excessive risk-taking. In this more volatile environment, there will be more personal (i.e. household) money (including that of the most vulnerable groups), especially as private pensions/superannuation become more widespread. Because of the complexity of the rules surrounding pensions, these investments will often be managed by professionals, so principal/agent problems arise which did not exist in a simpler world. The gross conflicts and dereliction of duty by investment advisors in America are currently coming to light, but there is no reason to think that they are confined to the USA.

One further problem. Business has become more complex, and the accounting system has not found ways of keeping up with and recording the full extent of this complexity. It may be a simplification of the “Good Old Days” to see that world as being populated by businesses with mainly tangible assets, whose presence could be verified by the accountants and auditors, and a valuation given within reasonable bounds. Now many companies have almost no tangible assets, and their worth lies in the way the various resources (staff, marketing machine, customer lists, brand names) have been brought together. Streams of future earnings are given value, even though the associated work has not yet been done. There is no dispute that these intangibles have value – we see this when such companies are sold. But we also see that this value can disappear quickly as markets change and evaluations shift. Of course this was always true with assets – even physical assets. But the potential for re-writing the accounting script seems much greater today than before, and the accountants have gone from being humble servants of the business to partners in the promotion of the stock. In September, the Chicago Tribune analysed the sad demise in the standards at Andersen. Even when the spirit is willing, the flesh is weak, as illustrated by the failure of the FASB (the US accounting standards board) to impose its view on the expensing of equity options. When, under lobby-inspired political pressure, they soften their stance to make this “recommended” rather than mandatory, 498 of the top 500 companies chose to ignore the recommendation (Buffet 2002).

–  –  –

When markets go sour, there are increasing calls for the government to “do something” about it. The first reaction is to get the government to compensate the losers. The political pressures to widen the net of government protection, ex post facto, is strong (we never contemplated rescuing any of the policy-holders of the failed Australian insurance company HIH, but here we are, innocent bystanders/taxpayers, reluctantly picking up some of the costs). The second reaction is to put in place regulations purporting to prevent recurrence. What is the right response to this problem?

There are two closely-related and sometimes-overlapping approaches that are relevant. The first is to re-examine the existing rules and codes of conduct, with a view to making them more effective (but without starting from the view- point that this means more of them). The second is greater reliance on market discipline, but with the recognition that markets don’t work particularly well, so we need to see what can be done to make them work better. Then, having done what we can to re-jig the rules and markets to make them work better, we need a third element: to put up a caveat emptor sign, so that the authorities are not blamed when markets and rules fail to protect investors (and the taxpayers are not lumbered with the losers’ losses)

Rules and Codes of Conduct

There will be much discussion at this meeting on the specifics of how the rules should be re-jigged. I will leave that to the experts in the specific

fields, and try to set down some broader principles of rule-making:

- Parsimony and simplicity

- Widespread involvement (“collective guilt”)

- Subsidiarity – devolve as far as possible

- Caveat emptor Parsimony The general case against overreach with rules is clear enough. Excessive


- Stops businesses from working efficiently by distorting their decisions: Rule to enforce prudence inhibit risk-taking and entrepreneurship: they stop the managers from managing. They create moral hazard.

- Introduces expensive “sand in the wheels” of enterprise through

compliance costs:

- Inhibits market discipline – the more the regulators do, the more they distort of emasculate market controls.

- Some rules make things worse because they are not congruent with the markets view – e.g. hedging for mining companies.

- Worst of all, if you set the rules, you will get he blame, even when it is inevitable that things will go wrong.

For my taste, the case can be made in a single sentence: “Beware the Nanny State: it will be run by lawyers”.

Let me go from the general to a specific example of over-reach. There seems a strong tendency to react to perceived deficiencies in governance by requiring directors to get more involved in the job of managing the company, and to take responsibility for it. Let me quote from the Commonwealth Secretariat’s Checklist for financial sector governance (Commonwealth Secretariat 2001): “the supervisory authority (should) require bank directors and senior management to sign regular statements attesting to the effectiveness of risk management systems and to hold them responsible if it transpires that these attestations were misleading or false” (my italics). The distinction between the management role and the directors’ role may be tricky to define in practice, but to confound the two roles and treat them as equally responsible seems an unhelpful way to go, if we are at least as interested in the efficient running of the company in normal times, as we are in finding scapegoats when things go wrong. The manager’s job is to manage, and the director’s job is to discipline them (in extremis, by sacking) if they are not doing this properly, standing at one remove from the daily tasks. To expect the Directors to be on top of the complexity of a risk management system in a complex financial institution, to the stage where they can attest its effectiveness, is a case of over-reach.

If this distinction seems too subtle, let me give an example at the other end of the spectrum, where there the Directors should be exercising a strong control, but often are not. “Growing” companies seems to the fashionable jargon to include high on the list of a manager’s priorities, but it raises questions. From the shareholders’ viewpoint, growth of an enterprise should not, in itself, be a high priority – if an investor wants a bigger portfolio, purchase of additional shares is the way to go. It may well be that the opportunities for the highest return lie with another company. A company which has a highly-profitable niche market (lets call it Golden Goose Ltd) should not grow unless this market can be profitably expanded (if more golden geese can be bred in a cost-efficient way): to invest in lesser assets, just to get growth, would be a misallocation of shareholders’ funds. So growth in itself should not be an attraction for shareholders (unless it is shorthand for a whole lot of other more complex attributes, such as being in an industry whose growth will make it more profitable than average). But growth may well be a personal priority for management, even as an end in itself. Growth means a larger salary, more prestige, more experience, a better CV, a bigger office and a more luxurious car.

This is the sort of issue – where differences of viewpoint between shareholders and management may arise – that require the directors’ attention – not double-guessing the operations of the firm and constantly look over management’s shoulder. My impression is that directors can never know enough to effectively second-guess an active CEO (who, after all, controls most of the flow of information to the directors), and that governance rules which depend on them being able to do this will disappoint when things go wrong. If you accept this argument, then it seems quite wrong-headed to force this sort of role-confusion through overly-prescriptive codes which raise unrealistic expectations of what directors can achieve.

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