Heading straight into the next crisis
Posted on August 31, 2013
This article was first published in The Guardian
Credit agencies are loosening ratings, incentives are perverse and management lacks transparency – we’re squandering the chance for a sustainable financial system
A few years ago I did a tour of different asset managers to get an understanding of the available alternatives for managing investments. Each team came out with their glossy, prepared sales pitch explaining in excruciating detail the rationale for their investment strategies.
I was uninterested. Coming up with investment strategies was their expertise not mine. I only wanted the answer to two simple questions: what are your internal decision-making, management and control processes? How do you get paid? The arcane detail of investment strategy was not something I could hope to understand or critique. If it were, I would be doing my own investments and cutting out the not insignificant management fees. What I was interested in was whether these were well-managed businesses and whether the incentives of the investment managers were aligned with my interests as a client.
As regards the first question, nobody seemed capable of answering it. They were utterly surprised that I was asking and didn’t quite know how to reply. This was not part of their canned presentation. As for the second, the answer was invariably that no, the investment managers’ incentives were not aligned with my interests as a client.
It was a depressing experience. It therefore came as no surprise that thefinancial sector proved unsustainable and the financial crash ensued. Fundamentally, it was a result of two main factors: senior management in financial institutions turned out to be unable to implement adequate controls over what the traders and those constructing complex financial products were doing; and compensation systems were structured to encourage the greatest amount of irresponsible risk taking.
Have we learned anything since? Apparently not. The New York Timesrecently reported that Standard & Poor’s, the rating agency, had managed to claw back market share by handing out more favourable credit ratings than its competitors. So here we go again. We are not yet out of the woods from this financial crash and the next one is already in the making. It results from the same fundamental problem – misaligned incentives.
The real clients of the rating agencies are the users of the ratings – those, like you and me and the many who invest our savings and pension funds, who use the ratings to make investment decisions. Yet the rating agencies are actually paid by those they rate. The conflict of interest and misaligned incentives are clear for all to see. Protestations of innocence from management will not convince any of us in an age where professionalism has become a rarity.
The message to all of us is clear: once again the ratings issued by the ratings agencies do not seem to be worth the paper they are written on – and they will never be until incentives are properly aligned. The issue of misaligned incentives is widespread in the world of financial services. Ex-Goldman Sachs trader Fabrice Tourre has recently been convicted on six counts of securities fraud including “aiding and abetting” Goldman Sachs – a firm that is facing a class action suit claiming that it was acting for its own interests and against the interests of its own clients.
What applies to unsustainable financial markets applies to all aspects of businesses that wish to focus on sustainability as a core principle. Instead of, or maybe as well as, the many complex ways of trying to measure sustainability performance, two fundamental questions that need to be asked: (i) Are incentives within the corporation aligned, top to bottom, with building sustainability into the fabric of the business model? (ii) Does senior management have clear, transparent and effective management and control systems around sustainability performance? In my experience, the answer to the first question is almost invariably negative. The answer to the second is variable but tends to become increasingly negative the larger the corporation (for obvious reasons).
It has been said many times before that crises present great opportunities to achieve change for the better. The tragedy of the current crises – be it the financial and economic crisis, or the Eurozone debacle, or the continued environmental degradation, or endless other unsustainable practices – is that the chance to achieve change has been squandered.
While the crises presented golden opportunities to build sustainability into the framework of our economic and social systems, weak business and political leadership has, instead, chosen to focus on trying to get back, as quickly as possible, to a clearly unsustainable business as usual. Standard & Poor’s is doubtless only one example of many. For instance, one of the most toxic financial products ever devised, the interest only mortgage, seems to be making a comeback. So – here we go again. It seems that the wag who said that a crisis is the period between two other crises may not have been such a cynic after all. Sustainability be damned.