February 2010
Agents versus principals
In all the outpourings of angst over the global financial crisis there is one group that has suffered more than any other, yet its voice has been drowned out by politicians, the media and taxpayers. It is shareholders in banks that have been the hardest hit by this financial Armageddon. Some commentators would argue that speculators holding bank shares simply got their just desserts for holding such risky investments. That is unfair though because for most of the last half century bank shares were regarded as rather boring and less risky than other sectors such as technology and commodities. Moreover, many individual shareholders became accidental capitalists as a consequence of the demutualisation of a number of building societies. Few could accuse those venerable institutions of playing fast and loose in the world of finance in their original form.
The reality was that banks shares formed the bedrock of a great many portfolios ranging from individuals, income funds and pension funds. For those investors to have avoided a sector that was generating about £20 billion of dividend income, about one third of the total cash flow from the market, would have been nonsensical. Two years ago, before the great implosion, this sector was valued by the market at about £200 billion. That was a staggering large amount of capital.
So who was responsible for vaporising it? The simple answer is that it was largely in the hands of a small group of people who were, for a while, on the front pages of newspapers up and down the land. Sir Fred Goodwin, Andy Hornby, Sir Victor Blank and so on. In fact these men were not custodians of that capital but the agents responsible for deploying it. They, in the truest sense of the phrase, were merely managers. They did not represent the owners of that capital but were deploying it for the greater good of the shareholders.
The agents deployed the capital on behalf of the principals. But the rewards for the risks incurred went to the agents who organised the trade, not to those who took the risk. No wonder the system blew up. If the principals, the shareholders, had been properly rewarded for the risk, and kept the proceeds, the banks would all have had stronger balance sheets.
Of course history records that then, and even now, the executives made themselves very rich in the process. Not only did they reward themselves very handsomely through wages and bonuses they also decided that they would like to become shareholders as well. So they awarded themselves options enabling them to become part owners of the business. Unlike other shareholders though, they did not have to write out a cheque for their investment. They got the shares for free just for turning up and doing their job as directed by the owners. It’s not a perfect analogy but it is a bit like a window cleaner turning up on a regular basis, cleaning the windows of your house and, in addition to being paid, demanding and being given a small share in your house.
Most householders would not contemplate such an agreement. Why should they give up a part share of an asset to someone who is merely following orders? Yet this transfer of ownership is precisely what happened at the banks, and it is still going on. When Barclays sold its iShares business in 2009 Bob Diamond received millions of pounds for the shares he owned in that division. Did he buy them? I don’t think so.
It is this insidious dilution of the original owners of the business that is at the core of the financial crisis. Managers, the agents, acquired part ownership from the shareholders, the principals, by stealth and then treated all the capital in the same way. As if it was free.
In theory the rights of the shareholders are protected by the watchful eye of the non-executive directors. But take a look at the board of Barclays as an example. CEO John Varley, with 622,000 shares and Bob Diamond with 8.3m shares are executives, as is Finance Director Chris Lucas with 101,700 shares. They have to explain their actions to the shareholders and take instructions from the non-executives. But who are they?
The Chairman is Marcus Agius, a Swiss banker, so he doesn’t represent British shareholders but has 113,500 shares. John Sunderland, with 80,000 shares used to run Cadbury. David Booth owns 73,000 and used to work for Morgan Stanley. Simon Fraser with 46,000 shares was a fund manager at Fidelity before he retired. Fulvio Conti has 39,000 shares and currently runs Enel, the Italian energy company. Leigh Clifford with 35,000 shares used to run Rio Tinto and is now Chairman of Qantas. Richard Broadbent with 34,500 shares is Chairman of Arriva. Andrew Likierman with 23,000 shares is Chairman of the National Audit Office. Michael Rake with 15,000 shares used to work for KPMG and is now Chairman of BT. Finally there is Reuben Jeffery who spent 18 years at Goldman Sachs.
The non-executive directors are clearly there to cement business relationships. It is patently clear that none of them represent large, long term shareholders. There is no one on the board of Barclays Bank who is actively involved in managing money. There is no representative from Schroders, Prudential, Standard Life or Aviva, the biggest money managers in the UK. Neither is there any representation from hedge funds or sovereign wealth funds, many of whom will have capital invested in the bank. Traditional fund managers will of course declaim that they cannot be directors because it would generate a conflict of interest and would inhibit their ability to trade if they became privy to inside information. That is less relevant now because so much money these days is run on a passive basis. Portfolios are constructed totally independently of any “information” that fund managers might be able to acquire from a board meeting or anywhere else.
Passive mangers now have the worst of all worlds. They are custodians for pensions and ISAs yet can only stand and watch, passively, as large banks deploy that capital in a way that could destroy it.
Alan Greenspan, former chairman of the US Federal Reserve, was surprised by the financial crisis. He thought the self interest of all the participants would inhibit them from undertaking activities that were likely to result in such a catastrophe. The problem was that the agents of the crisis were not risking their own capital. The principals, whose capital was being risked, never got a chance to express their opinion.
There will be other financial crises, it is human nature. But it is possible to ensure that this one is not repeated. The first step would be to ban the use of share options as a means of incentivising bank executives. The second is for shareholders to ensure that they are adequately represented on the boards of banks. Once there they need to understand the risks that are incurred and ensure the return is sufficient compensation. Most importantly, they need to make sure the risk takers are rewarded, not the agents.