The Kay Report is not a long-term solution to problems in equity markets
3 August 2012
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Tax and Fiscal Policy
19 November 2024
Reading the final report of the Kay Review of Equity Markets is an unsettling experience, starting as it does in the tone of a Victorian blast from the pulpit:
“Short-termism […] is the natural human tendency to make decisions in search of immediate gratification, […] decisions which we subsequently regret. We […] eat and drink too much, and we do not save enough.”
Well, you may, John (though I’ll bet you don’t); and nor do I; nor do a few hundred million middle-class Chinese. This may sound facetious, but what is presented here as a truism is actually very questionable on a number of levels.
Firstly, defining excessive consumption is nowhere near as easy as defining overeating. Excessive – by what criteria? And even if we accept that we are a country of over-consumers (of goods and services or food), it does not follow that the government has the right, duty or ability to “improve” us.
As far as short-termism is concerned, the argument goes back decades, which suggests that, if it has any validity at all, short-termism must reflect something far deeper than the behaviour of a handful of fund managers or corporate moghuls.
Whereas the usual indictments of the City blame the financial sector for deliberately frustrating the natural long-term focus of British savers, Kay manages to have it both ways. He takes the line that, instead of somehow locking us into long-term investment, the City panders to our preference for short-term gains, a phenomenon which he believes is associated with a number of shortcomings, including the “financialisation” of the corporate sector (which I take to mean reliance on financial and accounting criteria for decision-making), the propensity to rely on mergers and acquisition rather than organic growth, incentive misalignment and many others.
Of course, the Report’s argument breaks down if markets are efficient and investors are rational, so, as background to practical considerations, the Report explicitly embraces behavioural finance. Sympathetic as I am to this argument, the Report cruelly exposes the weaknesses and contradictions which await those who abandon the intellectual discipline of the assumption of efficient markets.
For example, the Report advocates transparency (who wouldn’t?), but seems to suggest that too much information only encourages short-termism. Likewise, although shareholder impatience is at the root of the apparent problems discussed in the Kay Report, corporate governance apparently needs improving to give shareholders more direct control. And the list of contradictions goes on, helped by examples from recent history intended to bolster the Report’s argument but which could well be interpreted as the precise opposite (e.g. the GEC-Marconi bankruptcy, cited as a case of excessive financialisation, in spite of the fact that it occurred when the famously parsimonious accountant, Lord Weinstock, was replaced by an engineer who proceeded to buy a US hightech competitor at the top of the market, for cash rather than equity!)
The Report is at its most superficial when it sings the praises of trust. Many of our problems stem, it seems, from trust (or the lack of it). We are told that what we need is trust based on relationships: the only real trust there can ever be, based on personal acquaintance rather than on metrics and objective data. It was apparently the anonymity of financial markets and the consequent failure of lenders to get to know borrowers that caused the crisis.
This oft-heard claim is highly debatable. The crisis was just as much the outcome of too much trust – too many people who should have known better put their faith in the credit ratings agencies, in banks and in governments, instead of questioning their reliability and doing their own due diligence.
And as far as relationship banking is concerned – good riddance. When we had it in Britain pre-Big Bang, credit worthiness revolved around golf clubs, old school ties and the qualities that make an all-round good chap. We still have it in the Far East, though mitigated somewhat by the 1998 Asian crisis, for which it was largely to blame.
In any case, the notion that the crisis was the result of lenders not knowing their borrowers is extremely debatable. Obviously, an investor buying a securitised package of mortgages could have no direct knowledge of the borrowers, but that was not ultimately the problem. The house of cards collapsed because many of the mortgages had been marketed to high-risk borrowers who, largely at the instigation of politicians, were targeted precisely because of their low credit rating. This was a case of too much, not too little knowledge. It would have been less damaging if borrowers had been selected by a random number generator!
On the positive side, the Report is surely right to focus on the weakness of corporate governance in a world where the number of links in the chain from investor to company grows ever longer, but it proposes few remedies and gets sidetracked into irrelevant issues such as the geographic location of corporate HQ’s. Also, to its credit, it rejects all the tired old interventionist remedies for the failings of the investment industry, ending up relying on voluntary codes of practice – though they have no great history of success either in finance or the newspaper industry.
Laurence Copeland is Professor of Finance at Cardiff Business School
“Short-termism […] is the natural human tendency to make decisions in search of immediate gratification, […] decisions which we subsequently regret. We […] eat and drink too much, and we do not save enough.”
Well, you may, John (though I’ll bet you don’t); and nor do I; nor do a few hundred million middle-class Chinese. This may sound facetious, but what is presented here as a truism is actually very questionable on a number of levels.
Firstly, defining excessive consumption is nowhere near as easy as defining overeating. Excessive – by what criteria? And even if we accept that we are a country of over-consumers (of goods and services or food), it does not follow that the government has the right, duty or ability to “improve” us.
As far as short-termism is concerned, the argument goes back decades, which suggests that, if it has any validity at all, short-termism must reflect something far deeper than the behaviour of a handful of fund managers or corporate moghuls.
Whereas the usual indictments of the City blame the financial sector for deliberately frustrating the natural long-term focus of British savers, Kay manages to have it both ways. He takes the line that, instead of somehow locking us into long-term investment, the City panders to our preference for short-term gains, a phenomenon which he believes is associated with a number of shortcomings, including the “financialisation” of the corporate sector (which I take to mean reliance on financial and accounting criteria for decision-making), the propensity to rely on mergers and acquisition rather than organic growth, incentive misalignment and many others.
Of course, the Report’s argument breaks down if markets are efficient and investors are rational, so, as background to practical considerations, the Report explicitly embraces behavioural finance. Sympathetic as I am to this argument, the Report cruelly exposes the weaknesses and contradictions which await those who abandon the intellectual discipline of the assumption of efficient markets.
For example, the Report advocates transparency (who wouldn’t?), but seems to suggest that too much information only encourages short-termism. Likewise, although shareholder impatience is at the root of the apparent problems discussed in the Kay Report, corporate governance apparently needs improving to give shareholders more direct control. And the list of contradictions goes on, helped by examples from recent history intended to bolster the Report’s argument but which could well be interpreted as the precise opposite (e.g. the GEC-Marconi bankruptcy, cited as a case of excessive financialisation, in spite of the fact that it occurred when the famously parsimonious accountant, Lord Weinstock, was replaced by an engineer who proceeded to buy a US hightech competitor at the top of the market, for cash rather than equity!)
The Report is at its most superficial when it sings the praises of trust. Many of our problems stem, it seems, from trust (or the lack of it). We are told that what we need is trust based on relationships: the only real trust there can ever be, based on personal acquaintance rather than on metrics and objective data. It was apparently the anonymity of financial markets and the consequent failure of lenders to get to know borrowers that caused the crisis.
This oft-heard claim is highly debatable. The crisis was just as much the outcome of too much trust – too many people who should have known better put their faith in the credit ratings agencies, in banks and in governments, instead of questioning their reliability and doing their own due diligence.
And as far as relationship banking is concerned – good riddance. When we had it in Britain pre-Big Bang, credit worthiness revolved around golf clubs, old school ties and the qualities that make an all-round good chap. We still have it in the Far East, though mitigated somewhat by the 1998 Asian crisis, for which it was largely to blame.
In any case, the notion that the crisis was the result of lenders not knowing their borrowers is extremely debatable. Obviously, an investor buying a securitised package of mortgages could have no direct knowledge of the borrowers, but that was not ultimately the problem. The house of cards collapsed because many of the mortgages had been marketed to high-risk borrowers who, largely at the instigation of politicians, were targeted precisely because of their low credit rating. This was a case of too much, not too little knowledge. It would have been less damaging if borrowers had been selected by a random number generator!
On the positive side, the Report is surely right to focus on the weakness of corporate governance in a world where the number of links in the chain from investor to company grows ever longer, but it proposes few remedies and gets sidetracked into irrelevant issues such as the geographic location of corporate HQ’s. Also, to its credit, it rejects all the tired old interventionist remedies for the failings of the investment industry, ending up relying on voluntary codes of practice – though they have no great history of success either in finance or the newspaper industry.
Laurence Copeland is Professor of Finance at Cardiff Business School
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It should also be added that government persistently manipulates the savings rate – usually in order to discourage it. This is the main reason why we suffer from ‘excessive consumption’. In a free market there could be no such thing, but under a fiat currency where government is the major debtor this is the principal source of such distortions in the economy.
I do accept John Kay’s unhappiness with quarterly reporting of company results (in which he follows the splendid example, for once, of the European Commission!). The margins of error in annual profit and loss accounts are large enough: they are proportionately much much larger for quarterly profit and loss accounts. And there seems little doubt that too many managers are tempted to manipulate ‘interim’ results to meet ‘forecasts’ which they should never have allowed themselves to become even implicitly ‘committed’ to. In an uncertain world, there is no sensible basis for managers, or anyone else, to pretend to forecast future profits (or losses) with any precision. I hope everyone is learning some lessons from the apparent uncertainty about current macroeconomic statistics for the UK’s GDP: is it going down, or up, or is it flat? We don’t seem very sure. A bit more humility in pretending to ‘interpret’ such highly approximate aggregate statistics would be welcome.