John Kay - Finance needs stewards, not toll collectors

Finance needs stewards, not toll collectors

Trust in the financial sector is at an all-time low: only 10 per cent of respondents to a recent ITN poll believed that bankers told the truth. That places bankers even lower than journalists and politicians. Yet trust is the essence of financial intermediation. The core purpose of a financial system is to enable savers to have confidence in borrowers whom they do not know: confidence that they will earn the returns they expect and be able to realise their investment when they need funds. This is the issue I have explored in my review of UK equity markets, whose findings are published on Monday.

In the equity investment chain, asset holders and asset managers need to be trusted stewards of savers’ money. Company directors need to be trusted stewards of the assets and activities of the corporations they manage. In the absence of such trust, intermediaries become no more than toll collectors.

It is hard to see how trust can be sustained in an environment characterised by increasingly hyperactive trading, and it has not been. Trust is essentially personal and cannot easily be found in a dark pool. Impersonal trust can be established only in a rigidly disciplined organisation – the kind that retail banks were once but are no longer – or by regulation of a ferocity that has not been achieved and is probably not achievable. Trust usually rests on a long-term relationship: the merchant in a foreign bazaar does not expect to deal with you again, and that expectation governs his behaviour.

The chain of intermediation in the equity market is long. It includes nominees, fund managers, fund of fund managers, insurance companies, pension fund trustees, retail platforms, independent financial advisers and more. As the chain is extended, the strength of any single relationship is diminished, yet trust in the chain can only be as strong as trust in its weakest link.

To achieve the fundamental objectives of equity investment – high-performing companies that generate strong and sustainable returns for savers without undue risk – the chain of intermediation should be shorter and simpler. Most of all, it should be one in which rewards are earned through long-term relationships rather than frequent transactions.

These rewards need not be exclusively financial. Discussion of incentives often begins today from the false belief that only cash can influence behaviour. True, many trading activities are so deficient in inherent job satisfaction that only the prospect of very large rewards would induce anyone to engage in them. But a system that depends on attracting people to base activities through base motivation is fundamentally flawed.

Most asset managers want to do a good job – earning returns for their clients through strong, constructive relationships with the companies in which they invest. Most corporate executives also want to do a good job, leaving the companies they manage in a stronger competitive position. Both asset managers and company bosses find their capacity to achieve these results diminished by an environment flooded with “news from the markets” that is not news at all, and a culture in which financial rewards – often of absurd generosity – are linked to measures of short-term performance.

In the 1970s and 1980s, financial market regulation largely abandoned a system structured to limit conflicts of interest, which encouraged businesses to build reputations on their performance of specialist functions. The new approach was based on behavioural regulation, designed to combat inappropriate incentives by detailed prescriptive rules. The outcome is regulation that is at once extensive and intrusive, yet ineffective and largely captured by financial sector interests.

Such capture is sometimes crudely corrupt, as in the US where politics is in thrall to Wall Street money. The European position is better described as intellectual capture. Regulators come to see the industry through the eyes of market participants rather than the end users they exist to serve, because market participants are the only source of the detailed information and expertise this type of regulation requires. This complexity has created a financial regulation industry – an army of compliance officers, regulators, consultants and advisers – with a vested interest in the regulation industry’s expansion.

In regulation also we need to go back to a simpler structure, serving the users of equity markets – savers and companies. Regulation should impose on all participants in the chain an obligation to manage their affairs to the fiduciary standards appropriate to anyone who takes responsibility for the management of other people’s money.

The events of the past few weeks may have been a watershed in British attitudes to financial services. Public opinion finally understands that the sector’s problems are not the byproduct of unpredictable events but arise from a wrong turning in the culture of an industry that has come to prioritise transactions and trading over trust relationships. We need an effective sector that meets the financing and governance needs of companies and the expectations of savers. We need a structure of regulation, and of the financial services industry itself, that establishes an appropriate structure of incentives and rebuilds trust and confidence on the basis not of public relations, but of changed behaviour.


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