Thursday, June 02, 2011

The Unacceptable face of Capitalism

The point about free markets and an open and transparent economy is that they should reward success and penalize failure.

When competition becomes limited and access to markets or capital is denied, then individuals or corporations can behave in non-market ways. We are now seeing more and more examples of this happening: the corporate leader who presides over falling profits and faltering performance still managing to increase his compensation package, for example. This perverse result is justified on the grounds that "the competition for talent requires greater rewards for managers". The result is today's news that FTSE Chief executives have on average gained a 32% increase in their remuneration over the past year. Meanwhile the FTSE itself has only gained 7% and average workers pay has gained only 2%- or a fall of at least 2.5% in real terms. In other words the CEOs are gaining at the expense of both shareholders and of staff. This is not, in my view, the result of fair competition, but of the result of too many barriers to fair competition.

One of the major barriers to fair competition is the way that Asset Managers run their investment portfolios. When you buy an investment fund, say UK equities or an East Asia fund from an investment specialist like M&G or JP Morgan, in theory you are buying the management skill of the asset manager. In fact you are buying 90% exposure to a standard benchmark. Asset managers are compelled to keep very close to the proportions of the index that they invest in. The result is that most funds actually actively trade only 10% of their assets. The fact is that they cannot sell out most of their holdings, even if they wanted to, because this would introduce too wide a "tracking error"- that is the gap between the fund portfolio and the underlying index. This is deemed to be "unacceptably risky". Furthermore, asset managers will base their relative preference for one stock over any other to a great degree on the management of the company in question. In other words they will very rarely seek to oppose the management of a company, but rather- at worst- they would leave the stock "underweight" in their portfolio. Only a very few active fund managers will quiz a management in detail on its corporate strategy, still less its policy on management remuneration. Given that roughly 70% of the ownership of a typical FTSE stock will lie with these essentially passive funds, it essentially means that there is no brake on the greed of the management coming from the source that would have the most power, that is the owners of the company: the shareholders.

The City has thus developed a cozy cabal with the management of industrial companies. The asset managers do not pressure the management of the companies, unless under exceptional circumstances. Meanwhile the non-executive directors, who are supposed to oversee the company are drawn from an exceptionally narrow pool of individuals, most of which are directors of several firms and many of which have backgrounds in finance. Furthermore, many of the same financial conglomerates that run asset management businesses also run corporate finance businesses and stock broking businesses that pitch for mandates from the companies that their asset management businesses own. In theory there are procedures, the so-called "Chinese walls", that prevent a firm from mixing their different businesses in order to maximize the advantage to the financial firm. In reality, there is at the least an awareness that being an activist shareholder may have repercussions for other parts of the financial firm's business.

Meanwhile the greatest disconnect between performance and reward has of course been taking place in the banking sector itself. Managers of financial businesses have been paid millions for costing their shareholders money: indeed destroying so much corporate value that governments have been forced to nationalize the banks.

It might have been an ideal opportunity to force significant changes on the way the banking sector works, but in fact governments have tended to behave even more like absentee landlords of the banks than the private sector investors were. The result is that, despite continuing losses, the taxpayer continues to fund excessive pay amongst the bankers. It is not the politics of envy to describe banking pay as "excessive" when the performance remains loss making: it is a statement of simple fact. More to the point, by combining different banks into larger groups, the banking system is being made significantly less safe for the future. If HBOS or Bradford and Bingley were deemed "too big to fail", then what are we to make of the gigantic "Lloyds Banking Group"?

It is quite clear that the banking system in the UK needs far greater competition. It is equally clear that there is a well entrenched resistance to this across the City. It is not an accident that the Minister known to be most keen on forcing change in the City, Vince Cable, has been the target of several dirty tricks seeking to discredit him before he can take on these entrenched anti-market forces.

The fact is that the City, like the print unions or the Miners before them, has become the home of special pleading and entrenched self interest, that seeks to steal extra benefits from the rest of society by behaving in an anti-competitive way. The free market has been undermined by a corrupt system that refuses to address the huge conflicts of interest that its faces. The irony is that their actions are justified in free market language.

The investment funds may control the majority of capital in the UK, but they do not behave in a particularly capitalist way. Instead of maximizing value by actively pressuring and monitoring their investments, they have been content to see their value languish under often lacklustre management. Meanwhile entrepreneurs can not get access to these large pools of capital because the understanding of risk in the City is limited to mechanistic and failed risk models built around benchmarks and tracking error.

Slowly the industry is changing: at one extreme there are more straight index funds, that simply buy an index and does no more and thus charges only a small transaction fee. At the other extreme there are more active managers who trade 100% of their portfolio, not merely a 10% tracking error. However it is a sign of how low the market competition is, that there are still so many money managers that continue to charge active management fees while essentially following an index return (and more often than not even under performing the index). Active funds, particularly ones that invest in private deals or venture capital, still remain only a small part of the so-called "alternative investment" universe.

Nevertheless the process of even this evolution has been glacial. This represents a massive distortion in the whole structure of capitalism. The result has been a total disconnect between the winners, the leaders of corporations, and the losers, who are the remaining workforce and the shareholders, who under the capitalist system are supposed to be supreme. This is creating not only a divided society, but an unfairly divided society - one where the winners are not gaining wealth and position through merit, but because of a system that they are rigging in their own favour, and at the expense of others. The social chasm that is being created can eventually only lead to significant social conflict, and that is already beginning to happen across Europe, in Spain and Greece, for example. The bankers are bleeding the rest of society through their own mistakes, and although I admit there are a myriad of other contributory factors, increasingly the focus is going to be on the outrageous unfairness of the current system.

The irony is that the failures of Capitalism are the result of market failure based on a lack of transparency and open competition; rather than too much Capitalism, the problem is not enough Capitalism.

However, the time has clearly come to directly address this growing crisis. The retail and investment banking systems must be broken up, root and branch, leaving a larger number of much smaller institutions. Investment Funds must take greater responsibility for the corporates that they own and control. Much greater accountability and transparency must be brought into the boardroom with best practice setting clear limits to the salary differentials within a firm. The operations of investment banks, particularly those that use large savings/deposit bases to fund risk capital investment should be the subject of a Royal Commission.

The failures of the banking system demands that government as the voice of the whole of society, and in many cases as the new owner of the banks, they must act proactively to open up and change the increasingly closed and occasionally criminal activity of the Bankers.

Speaking as a 20 year veteran of the City myself, I think it is long overdue that the system was challenged to justify itself and to change.

It is time that success was rewarded and failure penalized, and not the other way round.

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