Not more regulation, more Responsibility

If shareholders had closer relationships with the companies they invest in, a more accountable sector could be forged, says Colin Melvin, the chief executive of Hermes

If there is to be real change in this country following the banking crisis, then it's imperative that the UK's big shareholders build a much closer relationship with the companies in which they invest. As one of the country's biggest investors, we at Hermes believe that this is fundamental to restoring the public's trust in the financial system and improving risk management within the banking sector. Shareholders had become remote and unaccountable – we need to become involved and socially responsible.

As the banking industry debates its future, it's not enough to argue that the speculative activities and behaviours which led to several high-profile bank failures can be quelled just by adding additional layers of regulation.

Major changes are needed to the way banks manage risks, to the quantity and quality of capital they hold and to their regulation and monitoring. This will contribute to sustainable and stable financial markets. But there also needs to be a fundamental change in the culture of banks and financial institutions, which will benefit the wider economy.

There have been many casualties in the recent crisis. Ultimately, society at large has suffered the greatest losses and we all have a responsibility and an interest in the rebuilding of a system which rests on stable foundations. Through our savings with institutional investors, such as pension funds, many of us were shareholders and therefore joint owners of the banks worst affected by excessive debt, overtrading, poor risk management and misaligned incentives.

Although custodians of the lifetime savings of millions of people and shareholders in many thousands of companies, such institutional investors are generally remote from the management of the assets that they own and have no relationship with the companies in which they invest.

They have witnessed risky merger and acquisition decisions, excessive and misaligned executive remuneration, and powerful executives clinging to the dual roles of chairman and chief executive. They have also observed poor risk-management and short-term business strategies by companies operating with little or no accountability to their long-term owners.

The publication of the Walker Review of Corporate Governance in UK banks will be an important milestone in the history of our banking system and will have implications for the direction and control of all public companies. We welcome the Review's intention to repair the fault lines that appeared during the financial crisis. Hermes Equity Ownership Services (EOS) shares the review's assessment that limited adjustments – rather than a radical overhaul of the existing governance framework – is the right approach to take.

The review is right to focus upon the key areas of risk and remuneration while seeking to understand how best existing practice should be applied to company boards. We also support Walker's proposals for a Board Risk Committee. Banks should not approve new products or engage in complex strategies without the fullest possible understanding of the risks involved. Government and financial regulators can not do this for them.

However, the most important section of the review has been either misinterpreted or overlooked despite it being crucial to the proper functioning of our economy. That is its recognition of the need for large long-term shareholders, such as pension funds and life assurance companies to take a more active role in the stewardship of our most valuable assets.

Even before Walker's suggestion that this was the missing link in achieving an accountable capitalism, there was growing recognition among the world's biggest pension funds that a positive dialogue with the boards of the companies they own would contribute to restoring stability and prosperity. Creating a capitalism which is built on accountability and a sense of common purpose, will not only benefit society at large, but allow us to hand on companies as healthy engines of wealth creation to future generations. Responsible asset management and ownership have to move beyond good intentions.

By promoting the re-emergence of a culture of ownership and a reinvigoration of investment and saving for retirement we can develop in the City and the country increased social responsibility through an efficient and effective capitalist system, with minimum state and regulatory intervention. A well functioning financial sector should connect the providers and users of capital and offer valuable services to each. A functioning and progressive financial services sector in the UK should rebuild trust and engender a savings culture based on traditional principles of sound money management rather than taking on excessive amounts of personal debt.

We can also learn from enlightened practices elsewhere. There is a fresh wind of change globally which will allow everyone who paid the cost previously to benefit. Across the Atlantic, President Barack Obama is promoting a new culture of transparency and has recently demonstrated that his administration will not tolerate the corporate excesses which contributed to the recent financial crisis. A notable example of this is the recent plan by Kenneth Feinberg, the wonderfully named special master of compensation at the US Treasury, to cut the salaries of leading bank executives. However, on this side of the Atlantic it is incumbent upon the shareholders of UK banks to ensure executives are properly incentivised and their interests aligned. This may involve excluding from the calculation of bonuses those profits earned, in effect, from state aid, whether this be from loans or the government-backed purchase of bank investment products.

There needs to be a culture of long-term investment and corporate management, a rebuilding of trust in the financial sector and increased accountability in the relationship between shareholders and the companies they own. There also needs to be a greater connection between financial institutions and the workers, consumers and homeowners who depend upon them to manage their pensions and savings. The public has paid a huge price as a result of risks taken by financial institutions which became increasingly complex, opaque and inter-linked.

The credit crisis has demonstrated the economic interdependencies of our institutions and the wide systemic risk carried by banks. What happens in the financial services sector is inexorably linked to the health of our economy. The solution to the problems we face involves the promotion of savings, a reinterpretation of fiduciary duty to elicit and legitimise longer term behaviours within financial markets, the encouragement of "responsible asset management" by the investment industry and,, of course the facilitation of better ownership and engagement by end asset owners.

All our destinies are tied to the effective and healthy working of the financial system, which can operate successfully without excessive regulation if it is built on a sound value system and works for the good of its stakeholders. The cultivation of greater social responsibility will set us on course for a brighter future.

Hermes: Former Post Office fund delivers globally

Hermes helps pension funds achieve responsible long-term ownership through Equity Ownership Service, which has more £40bn of assets under its stewardship.

Hermes offers investment ranging from funds to hedge funds, com- modities to real estate, private equity and specialist equity products. It has £20.5bn under management.

Its investment portfolio includes fixed income (38.9 per cent), UK equities (2.1 per cent), overseas equities (12.1 per cent), hedge funds (9.4 per cent), commodities (5.2 per cent), private equity (6.8 per cent) and real estate (26.4 per cent).

It was set up in 1983 as PosTel, having been formed from the Post Office Staff Superannuation Fund. It is now a global fund management business with 202 clients and 398 staff.

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