The failures that caused the current credit crisis are the same ones which brought down Enron, Worldcom and Parmalat: lack of accountability, lack of responsibility and lack of transparency.
Capital markets can serve us well. But if they lack accountability and responsibility, that is a toxic mixture. The security of our investments depends on these basic tenets.In US credit markets, the most regulated capital markets in the world, the predictably weak links in the “chain of accountability” have now fractured.
So, what happened and what can be done about it?
In the past, when a bank made a loan, it was held on its balance sheet. It owned the loan and was therefore concerned that its customers were credit worthy. However, the bank could make more loans if they were held in a special purpose vehicle off its balance sheet. To take advantage of this, many loans were made to individuals, banks and others, then packaged up and sold on to “the market”.
This process of disintermediation meant that banks had less need to check credit worthiness. Instead, they had incentives simply to write more loans, take a fee and sell on the loan. To be assured that these loans were credit worthy, the market passed on this accountability and responsibility to credit rating agencies. These agencies are a regulated oligopoly – they are paid for by the issuer of the loan and so cannot avoid concerns about conflict of interest. They often sell other services to organisations whose bonds they rate.
Further, accounting standards had increasingly adopted the “fair value” approach to constructing a balance sheet. Old principles of prudence can often be sacrificed by adherence to such rules, especially where there is no market for the securities in question. This can temporarily flatter profits, balance sheets and bonuses, but does not foster a sense of responsibility.
Holders of these credits behaved as traders, acting in exactly the way John Maynard Keynes, the economist, forecast they would. Traders bet against each other and seek out performance, with little concern for the performance of the market overall.Outperformance is a zero sum game.
These problems will only now be solved by a greater focus on ownership, accountability, responsibility and transparency. There could be value in reviewing banking regulation and accounting, particularly in regard to off-balance sheet finance.
Don’t we need tighter standards for credit rating agenciesto ensure their independence? The official US oligopoly on CRAs could be reviewed, especially if CRAs cannot show in what ways they are independent of those whose bonds they rate. There should be a review of whether it is appropriate that they sell other products, and if they do, what transparency is appropriate. Investors could initiate and lead this – and be held accountable for their conclusions.
Shouldn’t we slow the dash to International Financial Reporting Standards and their focus on fair value? We need to be very clear about the effects of adopting a market-based valuation, particularly when no market exists. Investors should be better represented on the International Accounting Standards Board, who are accountable for the standards adopted.
We need to focus on the role of investors as owners. After all, it is our pension and insurance companies that appoint boards, approve incentives, commission hedge funds and buy collateralised debt obligations. These groups need to seek a high market return just as assiduously as they seek outperformance on investments. Too often they fail in their responsibility to promote trustworthy markets.
Regulation alone is not the answer. America has lots of regulation, yet it is there that so many financial scandals have arisen. Further, regulation has the danger of adding costs and of simply shutting the stable door after the horses are long gone.
We need to constantly return to the principles on which successful capital markets are based. It is on those principles that all our investments depend. It is only the participants, not the regulators, who can ensure the accountability, responsibility and transparency investors need. When the post-mortem is conducted on the credit crisis, it will find the cause to be one which was identified thousands of years ago. As Aristotle said: “That which is common to the greatest number has least care bestowed upon it.”
The writer is chairman of Hermes Equity Ownership Services and is the co-author of The New Capitalists
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