When something goes wrong it is often easy to try to identify a single culprit. If what has happened has caused people pain or expense, having someone to blame somehow makes things better, especially if they are subjected to punishment. All those victims of crime who complain about their assailant receiving a light sentence would complain so much more had no one been apprehended and convicted at all because the fact that the guilty party has been identified and suffered some adverse consequences gives solace even where their punishment does not match the suffering they inflicted on others.
In some fields it is simply unrealistic to suggest that one person or organisation is to blame. The current recession is an example of this. Was it all the fault of the banks for lending to people who could not repay the loans? Of course not. Nor was it all the fault of the borrowers who should have known better, or the government who encouraged the illusion of borrowed wealth in order to further their own ambition for power, or the government appointed regulatory authority. All of these groups are to blame in different measures because each made very serious errors of judgment and the consequences for everyone are bad now and look set to get a lot worse before there can be a real recovery. (Although I say "banks", much of the worst lending was carried out by finance companies unconnected to banks, but I will use "banks" to describe all lenders for present purposes.)
One group which has escaped serious censure to date is the banks' shareholders. This is a curious omission because they were in a better position than government to see what was happening and take steps to prevent disaster. The most common structure of a company is pretty much the same the world over and is based on a system devised in this country over a hundred and fifty years ago. The company has directors who are responsible for the day to day management of its operation and shareholders who put up the capital with which it operates and hope to make a profit from the company's activities. Shareholders have great power, if only they choose to exercise it. They appoint directors and can pass resolutions requiring the directors to do (or refrain from doing) certain things. Where the business practices followed by the directors are patently risky (like 125% mortgages or failing to investigate the means of the borrower) that risks falls on the shareholders not the directors themselves (obviously directors might also be shareholders, but that does not alter the substance of my point).
So what should you do as a shareholder in such a situation? Essentially you have two options: licking your lips and grabbing the profits while they are being made (then, if you have any sense, selling your shares before the excrement hits the fan) or taking steps to bring the directors' activities under control with an eye on the long term. Take the first option, as banks' shareholders did, and you are as much to blame as the directors themselves.
In saying this I don't pretend it is easy for shareholders to secure the majority required to pass a resolution forcing directors to change tack. Many shareholders are only interested in immediate profits not in the future, still less do they feel compelled to consider the effect on the wider economy of the business that is reaping them a nice reward. Even those who are sure a big mistake is being made know the easier option is to sell their shares rather than try to change the way a massive business is being operated. In all this there is a type of shareholder who really should have known better, the institutional shareholders with a duty to look to the future, in particular pension companies. A great many pension companies hold shares in banks because they have been a safe historic investment producing a steady return.
Pension companies are themselves huge businesses, administering vast sums of money on behalf of those who will call on them for income when they retire. There are some people who invest a lot in pension funds and build up a pot of a million pounds or more, in some cases many millions. A far greater number put a little aside every month, maybe a hundred pounds or so, to give a modest boost to their basic state pension when they finish work. It goes without saying that 1,000 people investing £100 a month is the same as one person investing £100,000 a month, it's an awful lot of money however it arrives in the pot and it has to be invested sensibly to give the best return over a lengthy period. Pension fund managers know they have to spread the risk they are prepared to take, so they invest some in rock-solid investments with relatively low returns (such as government bonds), much less in fairly risky ventures which might make a packet or might fold tomorrow and most in solid long-term performers like banks. The precise balance they choose to strike between risk and return differs from fund to fund, but shares in banks loom large in almost all.
Shares held by pension companies represent a large proportion of the total number of shares issued by many banks, which means that the pension funds have the muscle to influence the way the banks do business. A pension fund owning, say, five percent of the shares in a bank has great power, far greater power than a five percent shareholding might suggest. If they are worried about the way the bank is doing business and start selling shares they can cause the price of shares to plummet. Some selling is part of the natural way of things and rings no alarm bells, the sudden sale of a lot more than average suggests the bank might be in trouble and causes others to sell just in case there is a problem. Such an event causes a problem in itself and the banks know it. Large shareholders can have a huge influence over how a bank does business if they express concern about lending practices. They won't do it publicly unless they have to and they won't do it at all if they fail to appreciate the need for concern.
One might think pension funds and other very large shareholders would have found a way to get the banks to avoid taking undue risks, after all there were plenty of warnings in financial circles about the difficulties that could result from loose lending. All to often, though, the pension funds fell into the same trap as the banks themselves, they looked only to what they can make this year without consideration for the damage their own business could sustain a little way down the line. No doubt one factor in this was the whopping bonuses payable to pension fund managers if they made a big profit this year, bonuses which would not be recouped if a loss is made next year. That cannot, it seems to me, have been the only factor. There was also the simple fact that the banks were making a lot of profit and to make a move which would result in that profit being lowered would be harmful in the short term to the pension funds those managers had to administer. Even those who saw difficult times ahead could, perhaps, be forgiven for thinking that difficult times would affect other potential investments more than bank shares.
Despite all this, institutional shareholders must look to the long term in order to protect the funds they are running because pensions are a long-term business. Most of their customers will rely on them for more than fifteen years of investment returns before they retire, so jam today is only part of the equation the question must always be asked whether tomorrow's menu will feature jam or humble pie.
The failure of institutional shareholders to exert influence on banks was not just bad for the banks it was bad for the funds those shareholders administer. Their duty to their customers was to protect the funds and if that meant getting heavy with the banks they should have done exactly that. I know it is easy to say this with hindsight but I do not speak with hindsight, I speak with foresight because the problems caused by lending too much against too little security was exposed, painfully, in the early 1990s. During the latter part of the 1980s we saw 100% mortgages and borrowers only having to say they earn £40,000 a year for a bank to accept it and make a loan. It was exposed as appallingly bad practice not just by the housing crash from 1990-1992 but also in a long series of cases in the courts in which banks sought to recover their losses from solicitors and valuers who were alleged to have been negligent in their work during the course of a house purchase. Time after time the damages recovered by the bank were reduced substantially because they contributed to their losses through negligent lending practices. Many an eminent judge accepted the evidence of experienced expert witnesses and concluded that lending without proper assessment of the borrower's ability to pay was a recipe for default.
Those cases were publicised throughout the banking and pension industries, yet within ten years the same thing was happening again. The banks should have known better and so should the pension funds. I think it's time they took their share of the blame.
In some fields it is simply unrealistic to suggest that one person or organisation is to blame. The current recession is an example of this. Was it all the fault of the banks for lending to people who could not repay the loans? Of course not. Nor was it all the fault of the borrowers who should have known better, or the government who encouraged the illusion of borrowed wealth in order to further their own ambition for power, or the government appointed regulatory authority. All of these groups are to blame in different measures because each made very serious errors of judgment and the consequences for everyone are bad now and look set to get a lot worse before there can be a real recovery. (Although I say "banks", much of the worst lending was carried out by finance companies unconnected to banks, but I will use "banks" to describe all lenders for present purposes.)
One group which has escaped serious censure to date is the banks' shareholders. This is a curious omission because they were in a better position than government to see what was happening and take steps to prevent disaster. The most common structure of a company is pretty much the same the world over and is based on a system devised in this country over a hundred and fifty years ago. The company has directors who are responsible for the day to day management of its operation and shareholders who put up the capital with which it operates and hope to make a profit from the company's activities. Shareholders have great power, if only they choose to exercise it. They appoint directors and can pass resolutions requiring the directors to do (or refrain from doing) certain things. Where the business practices followed by the directors are patently risky (like 125% mortgages or failing to investigate the means of the borrower) that risks falls on the shareholders not the directors themselves (obviously directors might also be shareholders, but that does not alter the substance of my point).
So what should you do as a shareholder in such a situation? Essentially you have two options: licking your lips and grabbing the profits while they are being made (then, if you have any sense, selling your shares before the excrement hits the fan) or taking steps to bring the directors' activities under control with an eye on the long term. Take the first option, as banks' shareholders did, and you are as much to blame as the directors themselves.
In saying this I don't pretend it is easy for shareholders to secure the majority required to pass a resolution forcing directors to change tack. Many shareholders are only interested in immediate profits not in the future, still less do they feel compelled to consider the effect on the wider economy of the business that is reaping them a nice reward. Even those who are sure a big mistake is being made know the easier option is to sell their shares rather than try to change the way a massive business is being operated. In all this there is a type of shareholder who really should have known better, the institutional shareholders with a duty to look to the future, in particular pension companies. A great many pension companies hold shares in banks because they have been a safe historic investment producing a steady return.
Pension companies are themselves huge businesses, administering vast sums of money on behalf of those who will call on them for income when they retire. There are some people who invest a lot in pension funds and build up a pot of a million pounds or more, in some cases many millions. A far greater number put a little aside every month, maybe a hundred pounds or so, to give a modest boost to their basic state pension when they finish work. It goes without saying that 1,000 people investing £100 a month is the same as one person investing £100,000 a month, it's an awful lot of money however it arrives in the pot and it has to be invested sensibly to give the best return over a lengthy period. Pension fund managers know they have to spread the risk they are prepared to take, so they invest some in rock-solid investments with relatively low returns (such as government bonds), much less in fairly risky ventures which might make a packet or might fold tomorrow and most in solid long-term performers like banks. The precise balance they choose to strike between risk and return differs from fund to fund, but shares in banks loom large in almost all.
Shares held by pension companies represent a large proportion of the total number of shares issued by many banks, which means that the pension funds have the muscle to influence the way the banks do business. A pension fund owning, say, five percent of the shares in a bank has great power, far greater power than a five percent shareholding might suggest. If they are worried about the way the bank is doing business and start selling shares they can cause the price of shares to plummet. Some selling is part of the natural way of things and rings no alarm bells, the sudden sale of a lot more than average suggests the bank might be in trouble and causes others to sell just in case there is a problem. Such an event causes a problem in itself and the banks know it. Large shareholders can have a huge influence over how a bank does business if they express concern about lending practices. They won't do it publicly unless they have to and they won't do it at all if they fail to appreciate the need for concern.
One might think pension funds and other very large shareholders would have found a way to get the banks to avoid taking undue risks, after all there were plenty of warnings in financial circles about the difficulties that could result from loose lending. All to often, though, the pension funds fell into the same trap as the banks themselves, they looked only to what they can make this year without consideration for the damage their own business could sustain a little way down the line. No doubt one factor in this was the whopping bonuses payable to pension fund managers if they made a big profit this year, bonuses which would not be recouped if a loss is made next year. That cannot, it seems to me, have been the only factor. There was also the simple fact that the banks were making a lot of profit and to make a move which would result in that profit being lowered would be harmful in the short term to the pension funds those managers had to administer. Even those who saw difficult times ahead could, perhaps, be forgiven for thinking that difficult times would affect other potential investments more than bank shares.
Despite all this, institutional shareholders must look to the long term in order to protect the funds they are running because pensions are a long-term business. Most of their customers will rely on them for more than fifteen years of investment returns before they retire, so jam today is only part of the equation the question must always be asked whether tomorrow's menu will feature jam or humble pie.
The failure of institutional shareholders to exert influence on banks was not just bad for the banks it was bad for the funds those shareholders administer. Their duty to their customers was to protect the funds and if that meant getting heavy with the banks they should have done exactly that. I know it is easy to say this with hindsight but I do not speak with hindsight, I speak with foresight because the problems caused by lending too much against too little security was exposed, painfully, in the early 1990s. During the latter part of the 1980s we saw 100% mortgages and borrowers only having to say they earn £40,000 a year for a bank to accept it and make a loan. It was exposed as appallingly bad practice not just by the housing crash from 1990-1992 but also in a long series of cases in the courts in which banks sought to recover their losses from solicitors and valuers who were alleged to have been negligent in their work during the course of a house purchase. Time after time the damages recovered by the bank were reduced substantially because they contributed to their losses through negligent lending practices. Many an eminent judge accepted the evidence of experienced expert witnesses and concluded that lending without proper assessment of the borrower's ability to pay was a recipe for default.
Those cases were publicised throughout the banking and pension industries, yet within ten years the same thing was happening again. The banks should have known better and so should the pension funds. I think it's time they took their share of the blame.
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6 comments:
I feel that the major reason for institutional shareholders failing to exert any measure of control or moderation over the banks is that, by and large, major fund managers and bank directors / senior management are allpart of the same cozy little "city village" and probably share the same ethos "money for me and the Devil take the hindmost". This is an anlogue of the "Westminster village" made up of politicians, MSM political journalists and senior civil servants.
In both cases, failure of the supposed "watchdogs" to act can be laid at the door of the "you scratch my back, I'll scratch yours" culture that these enclaves engender.
I'm sure you're right Mr Pogo. Vote for each other and large bonuses all round.
I wonder whether the same would have happened if bonuses for both bankers and pension fund managers were payable in instalments over five years and repayable for up to five years after receipt in the event of investments turning south.
An interesting post which I partly agree with. My real reservation is given the lack of transpancy in the banks' audited accounts how were the shareholders supposed to be able to assess accurately the level of risk.
No shareholder could have reasonably predicted the level of overseas problems the banks were exposed to just by using the publicly available information. The banks could I think have withstood the current downturn in property prices as they did in the last recession if they were confident enough to lend to each other on the basis of published information.
The real enemy was that all of them believed the others had something to hide, as indeed they did themselves. So the regulators have not kept track of what the banks were doing and neither have the Auditors - blame all round I think.
All very fair-minded and reasonable I do not doubt.
But remember, if we had had sound money in the first place, no bubble could have arisen.
So the people who suggested, encouraged, and imposed the system of deficit finance and fractional reserve are the real villains here.
Without their siren songs, none of these subsequent disasters could have got started.
Fair point, Mrs Smallprint, but there is an interesting twist in the current situation.
There is scope for shareholders, especially the large ones, to insist on more information being given. Many of the institutional shareholders were the very people who had bought the dodgy packaged loans. If anyone was in a position to know what was in them, they were.
They were all following the lemming principle (see my blog), if we all do this together it must be okay. Too many following the herd instead of using their own brains. They didn't really know what was in them (the packaged loans) - that was the problem - they just looked at the bottom line and said "yes please".
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