In the wake of the crisis almost everything to do with banks is being questioned - regulation, business models, corporate governance and ownership. Some fear that once burned, shareholders will be twice shy and may avoid bank stocks and bank debt altogether. State ownership is deemed a temporary measure but have private investors fallen out of love with banks? Writer Geraldine Lambe

In his book The Corporation, published in February 2004, author Joel Bakan, a professor of law at the University of British Columbia, likened the corporate "personality" to that of a psychopath. The corporation doggedly pursues only one goal, to create profits for its shareholders, without legal or moral obligation to the welfare of workers, the environment or the wellbeing of society as a whole; it will willingly hijack governments to escape regulation and promote free market solutions.

Mr Bakan's conceit, if a little laboured, has much to say about the run-up to this crisis - in all but the most crucial element: in the financial meltdown, years of shareholder value have been destroyed and the trust between owners and managers breached. It is difficult to know what it will take to fully restore shareholders' long-term belief in this sector, however, the blind faith that business managers will always follow strategies that create value has been annihilated.

But it is not just the banks that are under fire. Institutional investors stand accused of behaving like absentee landlords for lack of oversight of the banks they own. Bank boards are being sued by pension funds for issuing misleading statements about finances and bonuses, or for failing in their duty to properly administer employee and state-backed retirement plans. Does this human need to apportion blame signal a fundamental breakdown of the relationships which underpin the global financial system?

Web of responsibility

Unravelling the web of responsibility, accountability and liability for the financial crisis is not just a job for regulators and governments. Banks and investors must examine their own operational conflicts and fudged loyalties. Should bank executives focus on shareholder value or manage the business with its systemic role in mind? Are institutional investors the stewards of the business that they own or agents for the beneficial owners of their funds? Are non-executive directors there to represent shareholder interest or to serve as an independent extension of the executive?

The answers to these questions matter. All of the world's major economies are driven by the model of equity ownership in which managers and directors exercise the rights of ownership on behalf of shareholders. At the end of 2007, the average size of even the largest companies listed on the New York Stock Exchange was less than $60bn, while three families of mutual funds each controlled at least $1000bn in investment accounts. According to governance consultancy Nestor Advisors, institutional investors represent more than 80% of total UK equity market capitalisation and 60% in the US.

A flawed model

Shareholders struggle with their role as overseers of a company and shareholding as a means of value generation. As managers of pension and life funds, private client accounts and a range of pooled investment vehicles, institutional investors are ranked on their quarterly performance against competitors. This is a crucial tool used to retain investors and attract further investment. As the financial crisis has unfolded, this focus has been heavily criticised for encouraging imprudently risky strategies by banks in order to maximise short-term returns and for failing to engage effectively with management when problems became apparent.

Liz Murrall, director of corporate governance and reporting at the UK's Investment Management Association (IMA), says pursuit of value for investors is a valid approach. "The investment industry's primary responsibility is to secure value for their clients, the beneficial owners."

Moreover, Ms Murrall argues that in pursuit of value, asset managers did attempt to influence banks, either by selling shares or by engaging with management. She cites the performance of the UK bank index. "In the past few years, the bank index consistently underperformed the FTSE index, which suggests that many [asset] managers had disposed of their shares well in advance of the crisis. We also know from our members that those in a position to engage, sought to do so; they had meetings with management and sought to escalate their actions where appropriate. But, at the end of the day, they had difficulty in getting management to listen and change behaviour," she says.

If this vindicates investors, it underlines a fundamental flaw in the shareholder model for banks. The concept of securing shareholder value, supposed to underpin the healthy growth of a company, has failed. As 'owners', institutional shareholders have been shown to have interests as short term as the return on equity that banks pursued. Compensation structures that were supposed to align managers and therefore bank strategy with shareholder interest have led to unfettered risk-taking not long-term growth. The notion that such risk should be borne by shareholders has been shattered. Banks' systemic importance means that they cannot be allowed to fail; Lehman Brothers made clear what can happen otherwise.

"The broader systemic importance and wide range of stakeholders in the banking sector means that the shareholder model is not a perfect fit," says David Ladipo, a partner at Nestor Advisors, and co-author of its 2009 report, Bank Boards and the Financial Crisis. "When there is only idiosyncratic risk to consider, a focus on shareholder value is absolutely right; when significant systemic risk exists, this approach becomes more problematic."

Anglo-Saxon problem?

It has been suggested that the crisis is an 'Anglo-Saxon' problem. The argument is that the crisis may have been spurred by the global cheapness of credit and the huge interconnectedness of balance sheets, but the biggest bank losses are either at US or UK firms - such as Citigroup, Lehman Brothers, Northern Rock or Royal Bank of Scotland - or those which have adopted the structure and business model of their Anglo-Saxon counterparts - such as UBS.

Did the combination of Anglo-Saxon-style regulation, its aggressive version of free market capitalism and its distributed ownership model create the perfect storm?

We have a relatively clear picture of the regulatory failures and compensation-driven risk taking which have helped to create this crisis, but the part played by distributed ownership is much less clear. Has the 'anonymity' of institutional share ownership - which characterises Anglo-Saxon banks - played a decisive role? Critics say that the system in Germany, France and Italy, for example, where single owners who hold more than 20% of the shares account for 60% of market capitalisation, has worked better. Such owners, it is suggested, are able to have more impact on the risk culture and strategy.

Clearly, this theory is flawed. Other financial systems have not been immune to the crisis. Germany's banks, including IKB and state-owned Sachsen Landesbank, have also suffered losses and failures. Equally, JPMorgan and Standard Chartered, for example, both listed banks domiciled in Anglo-Saxon jurisdictions, have emerged from the crisis with reputation and profits in tact.

However, Ms Murrell acknowledges that the failure of shareholders to influence management behaviour demonstrates the "limitations" to the distributed model. Moreover, she says, the growing force of passive investors such as sovereign wealth funds is increasing dispersion and exacerbating these weaknesses.

"There are issues with dispersed ownership. And it has become increasingly dispersed," says Ms Murrell. "Sovereign wealth funds are taking a bigger interest in companies and by and large they are passive investors - ie, they don't seek to engage very much - and that actually dilutes the impact of the investors that want to engage."

She says that the IMA and other bodies which represent asset managers are contemplating ways in which shareholder engagement can be improved but the biggest hurdle to doing so is a rule which prevents owners acting together. "Going forward, we need to look at whether we can establish a mechanism where there can be more collective engagement, so that shareholders with a certain percentage [of shares] can engage with the investee company and ensure that the company doesn't seek to divide and rule. In that context, our members are concerned about the implications of being held to be acting as 'concert parties'. We'd welcome some clarification from the authorities that joint engagement in that manner is not going to fall foul of concert party rules."

Return to partnerships

Others believe that the crisis could, or should, lead to more fundamental structural changes - to ensure those that are taking risks ultimately assume responsibility for them. Michael Lewis, author of Liar's Poker and one-time employee of Salomon Brothers, believes that this crisis can be traced back to the moment when John Gutfreund, then CEO of Salomon, turned the firm from a private partnership into Wall Street's first public corporation. In doing so, he transferred financial risk from the partners to shareholders, and all of the other Wall Street investment banks eventually followed suit.

Mr Gutfreund also unleashed the dogs of war. As Mr Lewis says, no investment bank whose partners were wholly exposed to the downside would have levered itself 35 to 1 or bought and held $50bn in mezzanine collatoralised debt obligations.

The rise of the investment banking boutique - a sector which has blossomed as universal and investment banks have struggled - is posited as a signal of a return to something like the old order, or at least validation of the importance of independence.

Benoit d'Angelin, former head of investment banking EMEA at Lehman Brothers and now a partner at boutique firm Ondra Partners, believes we may witness a return to the kinds of structures that used to dominate Wall Street and the broader financial system.

"After the crisis, three types of banks will emerge," he says. "At one end of the scale will be 'utilities' - big, liquid, publicly listed banks. At the other end there will be partnerships like the old Wall Street investment banks. In the middle, there will be trading houses that will be owned by employees and outside shareholders. Their cost of capital will be high; they will probably trade at a low PE and pay hefty dividends in return for the higher risks taken by shareholders."

Mr d'Angelin is not alone in envisaging a new model. Paul Volcker, former chairman of the Federal Reserve and now chairman of a new economic advisory panel established by US president Barack Obama, suggested to a conference at New York University's Stern School of Business that perhaps it was time for a two-tier financial system. Commercial banks would provide customers with depository services and access to credit, and would be highly regulated, while securities firms would have the freedom to take on more risk and trade "relatively free of regulation", said Mr Volcker.

Aside from rebalancing asymmetric incentive structures, a separation of the most risky business from the rest would clarify the investment proposition for institutional investors. Ms Murrall does not discount such a notion. "There is a disparity between why one would invest in, say, a clearing bank and an investment bank and the difference between capital returns and income returns. There may be some merit in looking at [some kind of division], going forward," she says.

Stilpon Nestor, founding partner of Nestor Advisors, thinks any return to a Glass-Steagall-type separation is the wrong way to go. "The current crisis has failed to invalidate any particular model," he says. "Banks that have done badly are of every different type, from mutuals to investment banks to universal banks. There is simply no prima facie evidence that it is the ownership structure which has determined success or failure."

Banks (and most shareholders) have also resisted this idea so far. In April 2008, two activist shareholders pressed for Deutsche Bank to separate its investment bank from the commercial bank one week after Luqman Arnold, former CEO of UBS and a major shareholder in the bank, called for its investment bank to be separated from its wealth management business. Neither of the actions succeeded.

Mr Nestor maintains that the shareholder - and the diversified-model is sound, for banks as well as other corporations. The key is overhauling and revitalising the regulatory framework. "There are plenty of examples, such as Canada and Spain, where the shareholder model has functioned well because they had the right regulatory framework in place," says Mr Nestor.

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Guy Sears, Director of wholesale at the IMA

Board trouble

It is also about instituting a more effective relationship between owners and managers and that, in large part, depends on more effective boards. Whether or not new risk committees and new guidelines can transform bad bank boards into good ones remains to be seen. But even here, the model could come unstuck. The cumulative effects of bad press, legal action and the knowledge that the workload can only get more onerous as banks become more heavily regulated is making it more difficult to recruit new board members, particularly for the chairman's role. And finding suitable candidates not tainted by the crisis has shrunk an already limited pool.

"Many banks are being urged to overhaul or refresh entrenched boards; or they may need to replace those who have left because of the crisis. But there is definitely a reluctance to take on these roles," says Stuart Hall, a director at executive search firm Norman Broadbent, who specialises in senior executive and board-level searches. "People are asking themselves: 'Why would we want to do this? We have good reputations, why would we risk them? Why would we put ourselves in the firing line?'."

Another headhunter says that he has a list of positions which he has so far been unable to fill. "A lot of banks - even those not heavily exposed to the subprime crisis - are looking to beef up certain skill sets, such as risk management. But it is almost impossible to find candidates. Many with the right experience are unwilling to take on what is now seen as a poisoned chalice. Board members who have so far survived unscathed are running scared of making a mistake and being pilloried in the press."

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Stilpon Nestor, Founding Partner of Nestor Advisors

Institutional appetite

Finding suitable candidates for the boardroom would be an academic exercise if institutional investors do not want to own bank stocks anyway. Until the first week of May, when financial stocks rallied, they were showing little interest in this sector, still fearful of what horrors may lay hidden inside balance sheets.

The US market rally in May indicated relief that capital shortfalls identified by the results of the US government's stress tests of 19 large banks were not as big as some had feared. It also underlines the quixotic nature of financial markets, suggesting that investors are shrugging off their fears despite the revelation that 10 banks will need to raise a further $74.6bn to bolster their capital levels.

One bank stock analyst believes that the rally, whether led by traders or real money investors, does not signal a return to business as usual. He is sceptical about what the stress test results mean and worried there will be a second phase of the crisis. He says: "Without the additional capital, the affected banks - several of the US's biggest - are arguably technically insolvent. And suddenly markets seem to be ignoring the possibility of another retail mortgage tsunami when Alt-A mortgages [which require little proof of salary and switch to higher rates after a period of three or five years] reach their interest rate reset peak in 2011."

Moreover, he thinks that although the stock market rally suggests there is less fear of the crisis moving beyond residential subprime into commercial real estate debt or leveraged loans, this possibility still exists. Barclays Q1 figures revealed that it still has significant exposure to monoline insurers - some reduced to junk status and the rest teetering on the brink - via its structured portfolio. It has £3.8bn ($4.2bn) of commercial mortgage-backed securities wrapped by monolines (underlying asset value, £1bn, exposure after company voluntary arrangement [CVA] £1.9bn) and £20.9bn of collateralised loan obligations wrapped by monolines (underlying asset value £14.2bn, exposure after CVA £5.4bn). "If Barclays has this sort of exposure, then it is likely that others do too," says the analyst.

The process of recapitalisation by the affected US banks will likely be painful for shareholders - Bank of America and Citigroup have plans to sell additional shares and convert preferred shares into common stock, which will be very dilutive. But should the stress tests get it wrong and an institution deemed to be well capitalised need to raise more, or the crisis spill over to commercial real estate or other debt, then investors' faith in banks would evaporate. And banks' access to private capital would again be closed.

Unpredictable, uninvestable

Guy Sears, director of wholesale at the IMA, suggests the 'crisis' model of government intervention and new post-crisis rules could lead to long-term changes in investment patterns anyway. He says that tougher regulation (such as limitations on size or type of business) and greater reliance on "judgement" rather than on rules-based calculations, could seriously dampen investor appetite for bank stocks.

"Two of the key elements which determine the attractiveness of stocks are predictability and certainty. Some of the tools being developed to ensure banks are adequately capitalised, for example, are interventionist - in the sense that they are not based on a rule but involve judgement. This could mean a call [by regulators] for a change in capital ratios, or a change to what can be treated as Tier 1, Tier 2 and so on. This would have a significant impact on dividends," he says. "To the extent that such judgements change in line with the economic environment in a manner that is not predicted by rules and lead to uncertainty, this will be priced in by the market and influence investment."

This is already evident in the trading of UK bank bonds, says Mr Sears. "Certain bonds from banks that have been nationalised are being priced at places that have more to do with expectation of default than perhaps the underlying yield, because investors don't know whether government will change the terms on them. This, despite two very clear statements - one by Paul Myners [UK Treasury financial services secretary] and one by Ian Pearson [UK economic and business minister] - that powers under the UK's Banking Act are much more restricted in terms of changing bond terms, for example. Nevertheless, the market is nervous; and that is being priced in."

In extremis, the fear of judgement calls, or government intervention in times of economic downturn, may cause investors to withdraw from the sector, says Mr Sears. "If another sector is more understandable, transparent and predictable, then investors will gravitate to the safer area," he says.

The impact of this on the banking sector would be catastrophic. The withdrawal of institutional investors would devastate the bank equity markets; an unwillingness to invest in bank debt would do the same to credit markets.

What now?

The ideal corporation that offers the perfect balance between the needs of its various stakeholders, including the public at large, does not exist. And this crisis cannot be marginalised as an 'Anglo-Saxon' problem, or blamed on specific ownership structures or types of regulatory approach; banks of many types, size and jurisdiction have suffered. But if governments feel that large-scale bank failure is politically and economically unacceptable - where does that leave the ownership model for banks? Should we limit the size of banks so that there are none too big to fail? Should we adopt some kind of narrow banking or ensure that private partnerships undertake the most risky activities? Many believe that it will be difficult for governments to leave the industry untouched.

Some suggest that the answer may lie in changing the incentive structures for institutional investors as well as for bank executives. In a paper for the Alabama Law Review - The promise of hedge fund governance: how incentive compensation can enhance institutional investor monitoring - Robert Illig, assistant professor at the University of Oregon School of Law, argues that if institutional fund managers adopted a similar compensation to that employed by hedge funds and private equity funds, their interest and the interests of their investors would merge.

The use of a carried interest, the paper suggests, when combined with a hurdle rate and direct investment in the fund by its managers, results in a close alignment of interests between the fund managers and investors. In addition, the need to justify their outsize fees, plus the opportunity to earn such fees, provides strong incentives for private equity fund managers to closely monitor the conduct of their portfolio of investments. By encouraging institutional fund managers to behave like their private equity counterparts, "institutional investors would thus become powerful and efficient players in an enhanced market for good corporate governance", says Mr Illig.


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