Tonight:
4°c
After two years in which the market value of the banking sector as measured by the FTSE 100 index has gone from £325 billion to £35 billion, it is surprising how rarely people ask what the institutional shareholders were doing when the bank managements were setting off down the path to destruction.
The Commons' Treasury Select Committee probed a little in this area a few weeks ago and got a dusty answer from Peter Chambers of Legal & General along the lines that he had tried on several occasions to get Royal Bank of Scotland to address his concerns but they brushed him off. That makes Legal & General the honourable exception.
The majority of institutional shareholders did not appear to be acting as a brake on management. If anything, they were more likely to be cheering from the sidelines, or even urging the banks on to even greater excess.
Indeed, one of the unsung heroes in banking is HSBC's financial director Douglas Flint, who came under huge pressure from investors to gear up that bank's balance sheet so he could launch a share buyback but courageously refused.
Now it is time for the regulator to ask the question which Hector Sants, the chief executive of the Financial Services Authority, did at this week's meeting in Edinburgh of the National Association of Pension Funds.
Being a kind man, he phrased it in a way that pointed out politely how shareholders might raise their game.
In doing so, he demolished two convenient excuses for inactivity. One of these holds that shareholders need do nothing because markets will correct any excess. But the truth, as Sants points out, is closer to the opposite.
Markets these days encourage excess, as with trying to bounce HSBC into taking on debt, or Northern Rock into expanding its loan book ever faster. If there is an automatic correction mechanism, it does not work in time.
Second, institutions tend to think if they don't like something then all they should do is sell the shares.
Sants accepts the truth in this in terms of their narrow responsibility to clients but says we all have a wider stake in the system.
Thus shareholders also have a responsibility to make sure that good governance is maintained at least in large companies so that financial stability is also maintained.
Shareholders must think much more about the companies in which they invest and must challenge boards in terms of their governance, risk management and business strategy.
They have to get involved as if they mean it. They need, though Sants did not say this, to probe with the insight and tenacity shown by hedge funds, many of whom show perception and understanding in their research and analysis which is highly unusual among long-only investors.
Such probing led hedge funds like Lansdowne to go short of Northern Rock two years before it failed.
How much better for the system as a whole if, rather than going short, long-term shareholders had persuaded management to change strategy so such crashes might have been avoided.
Sants made a further point which must surely have made his audience squirm. He asked them if they knew and understood what they were buying when they went chasing after yield in the height of the frenzy two years ago.
He asked how much of that complex securitisation and financial innovation was "truly understood".
If the fund managers had been spending their own money rather than the clients', would they have worked harder to understand what was going on? There is a core assumption in the City that sophisticated investors know what they are doing. If they don't, what is the client paying for?
Time will tell how institutional investors will respond. Arguably their business model is flawed, with far too much money spent on indifferent money managers who chop and change portfolios not out of conviction but because they need to appear busy.
Arguably, fund management groups spend far too much of their money on marketing, and have too many salesmen running the business.
Arguably, they also have a severe agency problem, meaning that ultimately it is not their money they are playing with and they are therefore more focused on the success of the fund management business which employs them than on the clients' investments.
Sants has basically asked the question "what are fund managers for?" and provided some possible answers.
If the industry does not like those answers it will need to come up with some of its own which it thinks are more convincing as well as more comfortable.
Given its indifferent performance over the years, it might find that quite difficult.
