Monday, 4 December 2017

How to Change the Impact of the Financial System: Focus on the Investors

In today’s post we will turn our attention to the role of the Investor in the global financial dynamic, as although we spend plenty of time here in Financial Regulation Matters looking at the iniquities of the marketplace via the actions of banks, rating agencies, governmental agencies and financial regulators, the role of the investor is just as important, if not more so. Whilst an assessment like this is always valid, this post is reacting specifically to a report last week that investors are returning to the products that brought the world to its knees in 2007/8, all for increased returns. So, in this post, this issue will be assessed because, on a number of occasions here we have spoken about the potential rise of the ‘responsible investor’ since the Crisis; perhaps we should be more careful with such discussions in the future.

The role of the investor in relation to the causation of the Financial Crisis is no secret, with a number of analyses choosing to focus upon it specifically. In one Handbook, an analysis that was undertaken to describe the processes of investors in relation to the cycles surrounding the Crisis suggested that the pre-Crisis phase is dominated by the sentiment that a crisis cannot happen, and then the realisation that it can usually encourages a systemic shock that prevents further abuse moving forward (for a certain time anyway). However, whilst this ‘financial amnesia’ may seem obvious, the analysis suggests that the difference with this Crisis was that the extensive Quantitative-Easing (QE) programme has essentially removed that period of shock and consequence, which ties in neatly to the theme of this post. Another analysis suggests that what lies at the core of this hazardous dynamic between the investors and the financial system is that once investors, i.e. ‘retail’ investors, are differentiated from ‘sophisticated investors’ (SIs), the protections put in place are stripped away on the basis of an entrenched belief that SIs can police their own markets. It is likely for this reason that, in the aftermath of the Crisis, the Chartered Financial Analyst Society in the U.K. argued that fund managers and financial advisors should be forced to study financial history to reduce the likelihood of financial crises. Whilst this is obviously a good idea in theory, it is clearly a non-starter in reality; yet, this claim brings forward two issues: firstly, enforcing SIs to study is symptomatic of a system that cannot enforce strict regulations; secondly, allowing SIs to police themselves ignores one vital component – what drives an SI?

We have looked on a few occasions in Financial Regulation Matters at what drives the SIs, and we have looked specifically at what some are suggesting the future will be in relation to this question; one such post looked at the chances of an increased sensibility to social responsibility. Yet, whilst discussions like those are usually related to the aim of trying provide some positive or hopeful analyses, the cold hard truth is that SIs are only interested, principally, in one thing – the highest returns possible. The report from last week assesses this, and its opening gambit is revelatory: ‘investors are driving a revival of structured credit products that were a hallmark of the boom years before the financial crisis’. However, this report in the Financial Times on the 27th November is certainly not the first warning about the direction that most SIs are heading in, with reports from much earlier in the year confirming exactly the same worrying trend. The story, essentially, is an entirely familiar and predictable one, with SIs being seduced into re-termed structured finance products – the new ‘hot’ product is the ‘bespoke tranche’, which is simply a collection of credit default swaps (CDS) tied to the risk of corporate defaults – so nothing new here to report. So, the products are the same, and also the reasoning for why SIs are being seduced into these shaky fields are the same too; understanding the environment surrounding an SI is crucial to predicting their actions. Today, the situation is that so-called ‘junk bonds’ are providing particularly low-yields, and that corporate bonds are not providing the high yields that large investors apparently ‘need’, although this is another issue entirely. Whether it is investing in ‘bespoke tranches’, plain old Collateralised Debt Obligations, or now ‘Collateralised Loan Obligations’ – the collection of leveraged loans – the story remains the same; ‘with junk bonds at such low yields where else can you go? It pushes investors into the securitised world’.

Worryingly, the environment surrounding SIs seems to be deteriorating, not improving. One report discusses how a wave of fixed-income debt procured in the immediate aftermath of the Crisis is now maturing, with an estimated $1 trillion about to mature which leaves investors with the need to re-invest and find similar levels of yield on their investments. If that scenario comes to pass, which the research suggests it will, then investors will be sitting on an incredible amount of money, which is essentially blood in the water for the usual protagonists. It has been noted that, with respect to ‘bespoke tranches’, the large SIs have been unable to partake up unto this point because, quite simply, the leading credit rating agencies have not yet rated them – the dynamic is, irrespective of the efforts of post-Crisis regulation with respect to rating agencies, that SIs are still reliant upon the ratings of the agencies (internally, if not implicitly externally). So, as we can see… the scene is yet again set.

Ultimately, there is a justified fear emerging that a perfect storm is brewing. SIs will have an incredible amount of money that they need to invest (hoarding that money will garner no returns), safer and more regulated products are producing extremely low yields, and all that is needed is for the rating agencies to sign-off on the creditworthiness of these incredibly complex products and that mound of money can be injected into this specific system. What can we deduce from all of this? Well, the first thing is that the suggestion that finance professionals be forced to read financial history is probably the most appropriate, albeit unrealistic proposal on record. Secondly, the regulations of this institution or that institution, of this process or that process, of this product or that product, is essentially closing the door once the horse has bolted; the real focus needs to be on the dynamics that are inherent within the investment process. There are reasons why the blinkered pursuit of high yields exists, but in essence the true reason is a systemic one – the modern capitalist structure determines that everyone should be involved in the process to make money as fluid as possible for high finance; the pension schemes that exist in workplaces up and down the country are a way to mobilise the public’s money, with the motive of the public then being to maximise their retirement pot – how many employees would, in reality, be happy with their pension being slightly limited in the pursuit of sustainable and responsible investing practices? It is not the fault of these savers, really, because their savings from their employment have a tangible and real property attached to them, whilst for SIs they are just numbers on a screen. Yet, it may be the savers’ fault, because if they all withdrew their pensions at once, SIs and Governments would have to take notice and respond. The conclusion is, however, that it is simply safe to continue as is, lurching from crisis to crisis, acknowledging but never truly learning from the past – what is needed is a radical action to be taken for someone influential, as a group, to fully commit to the ideal of sustainable and responsible investing; whether that happens anytime soon, in an era where individualism and uncertainty reign supreme, is doubtful.

Keywords – investors, institutional investors, structured finance, financial regulation, financial crisis, @finregmatters

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