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John Kay's Critique of the Equity System

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I've long been a fan of the Financial Times' John Kay. Now I know why. Kay, in his real career as an Oxford economist, has just released a lengthy, at 40,000 words, "Review" of the UK equity markets and long-term decision-making. This sounds both forbidding and dismally dull. After all, this is a government report -- Kay put together a group to study the question at the request of a UK Secretary of State (in the UK, that's just a cabinet department head, not the foreign minister) for the scintillatingly-named Department for Business, Innovation and Skills. Kay gathered a pretty sterling advisory group, but this report is clearly his: Unlike most government reports, this one is written clearly and tautly with the occasional flash of dry wit. It is, well beyond its recommendations, supremely intelligent and sensible. It is not ideological, except in the sense that if we disagree, well, you're being ideological. It is, in the finest tradition of the Scottish enlightenment (Kay is Scottish), empirical. That, in a nutshell, is the Kay you read in his FT columns and in his books.

At the very least, anyone, from the Occupy Wall Street crowd to the Ayn Randians amongst us, wanting to learn about how finance really works in our benighted age should read this even if they reject Kay's recommendations.

The report, which has received little discussion in the U.S., is both a critique -- perhaps the most profound critique we now have -- of the financial crisis and the "financialization" of the developed economies since the '70s, and something of a manifesto. Kay is intent on "reforming" much of the equity-centric, transactional and complex ethos that began with the rise of the institutional investors and the development of modern portfolio theory and financial economics. His brief is both broader and more fundamental than, for instance, that other recent British report (which he applauds), the Vicker's Commission, with its recommendation for structural solutions (Glass-Steagall-lite) to the big-bank problem. Kay, in fact, makes a convincing case, particularly in the must-read first half of this report, for the centrality of the equity system in the development of what we think of as modern capitalism and finance. He is focused on the chain of financial intermediation that extends from savers to asset holders (institutions like pension funds) to asset managers and other specialized intermediaries, to corporations with their directors and managers. He sees an attenuated chain replete with misaligned incentives, conflicts and superfluous, fee-scraping layers -- weak links. In doing so he tackles everything from governance issues to economic theory (he dismantles the efficient-market hypothesis) to what he would see as the overriding issue: whether increasingly short-term traders and markets can satisfy the needs of savers on one hand, and encourage the long-term growth of corporate value on the other. He believes the current system, with its emphasis on short-term transactions and its weakness for "hyperactivity," whether in trading or in M&A, is destructive of long-term value.

Like Keynes, you can endlessly quote Kay. Here he is on the relationship between shareholders and companies, which implicitly wrestles with the governance gospel of shareholder oversight:

The issue that concerns us is not whether there is too little shareholder engagement. It is whether the messages that managers and shareholders convey to each other, at meetings and through the share price, provides a framework within which companies and their boards can make balanced assessments of the measures needed to promote the success of the company in the long run. Shareholder engagement is neither good or bad in itself: It is the character and quality of that engagement that matters.

Kay resists the notion of shareholders as ultimate owners. Not only does he recognize just how far most savers are from the ultimate source of growth and value, the company, but he sees how large, diverse portfolios drive pension funds and asset managers to view everything as a portfolio question -- a transaction. Trust erodes. Relationships become contractual and riven by informational asymmetries. And callous self-interest is freed from the restraints of what should be a fiduciary or -- this is the heart of Kay's vision -- a sense of stewardship. What's lost? Any sense of the longer-term.

Here is Kay on the necessity for "successful" financial intermediation (note how far and how efficiently the logic of Kay's argument sweeps you down the path):

Successful financial intermediation is therefore a means by which the expertise of the intermediary enables savers to derive the benefits of diversification and liquidity while minimizing the disadvantages resulting from the loss of information and control inevitable in more distant and fragmented relationships. The problems resulting from imperfect knowledge and the divorce of ownership and control are generally described by economists as problems of information asymmetry and principal-agent relationships. ... [They] become steadily more serious as the modern corporate economy evolves. As companies grow in complexity, shareholders necessarily know less about the business in which their funds are invested: as companies become larger and shareholding more fragmented, relationships between savers and the management of the companies in which their funds are invested become more distant and the potential for their interests to diverge is increased.

Can you really argue with that?

Kay paints a picture in which the equity markets, which include savers and corporates, seem to be slowly strangling themselves. Primary equity issuance is down, public listings in the UK and U.S. have fallen, and initial public offerings have not been the same since the dot-com bubble. And, of course, there are various corporate and financial disasters to explain away. The UK, which saw its financial system fundamentally redirected in a free-market direction in the Thatcher era (Kay blames the invaders from Wall Street), has seen many of its larger and more iconic companies broken up, fail or be taken over by foreign entities. The aftermath of Big Bang, which saw the near-elimination of British finance by foreign firms, is not an exception but the rule. Kay is not arguing for protection (he is ambivalent about M&A but wary of overt regulation of deals) as much as recognition that domestically based corporations bring benefits well beyond just share appreciation. Indeed, early in the report he puts his finger on one of the key insights, which runs throughout this transactionally intensive regime:

A by-product of the growth of intermediation has been a tendency to view the performance of the market through the eyes of intermediaries. ... Goals such as liquidity, transparency, and price discovery have come to be regarded as ends in themselves, not as intermediate steps toward the underlying objectives of high-performing companies and good returns for savers.

So what is to be done? It's no particular knock on Kay that the second half of the report, which offers recommendations, is not as convincing as the first, the diagnosis. The issues are difficult. And Kay is not one to avoid knotty matters replete with ambiguity and complexity. He is not a fan of more rules, for instance. He recognizes not only that the system is choking on rules and regulations, but that the current system, despite its appearance of deregulation, fosters a kind of rule-mania. He also sees how this kind of fragmented, conflicted system produces, almost inevitably, regulatory capture. (He also doesn't spend much time on compensation -- one fairly short chapter -- that he sensibly sees as a result, not a cause, of deeper problems.) His answer? The core notion is stewardship -- that is the role of serving as a surrogate for another, with its very British sense of mutual accountability. Stewardship informs many of his recommendations. Stewardship is a relationship, not a transaction. All the links in this chain -- asset holders, asset managers, directors -- should have a sense of responsibility to act in the best long-term interest of their various clients. The government needs to create a business environment that encourages such long-term sense of responsibility, but the real discipline must be imposed by the chain of intermediation itself. Stewards should be fiduciaries, which Kay recognizes needs some legal clarification.

Too often, however, when it comes to action, Kay substitutes substance with rhetoric. He offers up suggestions for incentives and structural change, but there's still a gap to be bridged. How will this transformational cultural change occur? (This skepticism may rise from an American perspective on all this, where the forces of governance and efficient markets are dug in very deeply and the politics are intensely polarized.) "Stewardship is incompatible with conflict of interest." True, but how do you encourage what he calls the core fiduciary duties of loyalty and prudence in a system that handsomely rewards self-interest and gambling? There are ways to dampen short-term trading and speculation and encourage investment, but do you get the various links in the chain to act for the long-term -- to think, as Kay suggests, like Warren Buffett? How do you move companies off quarterly numbers or equity-based metrics? How do you tell the armies of well-paid consultants, trustees and analysts to stop cluttering up the joint? At the end of the day, Kay is sketching out a moral critique. But how do you induce the residents of Sodom to try a new life?

That said the great value in this is the quality of Kay's analysis of the problem. Finally, someone of stature who can think and write and who has a government pulpit to preach says what has been increasingly clear: There's something wrong with the financial system and it has to do with equities. That alone is a start.

This was originally published on TheDeal.com.
Robert Teitelman is editor in chief of The Deal magazine.