Musings on the 100-page report into the ‘no longer fit for purpose’ City culture

A long-awaited review into the City of London that looks to stamp out the ‘short-term’ nature of the financial sector has been published today. As it’s commissioned by Vince Cable’s Department for Business Innovation & Skills, you wouldn’t expect it to be particularly positive, and it doesn’t disappoint.

Written by economist Professor John Kay, it’s a hefty piece of work, coming in at around 40,000 words, and outlines how we got to the current scenario and recommends how the culture should change (admittedly, in the long term). It’s based on interviews with key players in the financial sector and has the weight of the government behind it. What do you need to know?

1. There are too many traders, and too many middle men

A crack down on prop trading, the electronification of equity markets and poor performance have all seen investment banks shrink their trading divisions in recent years. They have yet to go far enough, suggests the report.

“There should be fewer of them and they should be paid less. The objective of financial markets is not to provide jobs for traders,” said Kay. “We need a philosophical shift in the way people think about markets.”

There’s also the complex chain of intermediation, which increases the costs and reduces trust between investors and companies. This includes fund managers, pension trustees, investment consultants and independent financial advisers, says the report.

2. The sell-side analyst will be phased out

One of the main victims of reducing the ‘chain of intermediation’ will be the sell-side research analyst, which Kay describes as “dispensable”. The job is already evolving into one where analysts write large, exhaustive reports into industries and macro-economic trends, rather than individual stocks and this looks set to continue.

“Issuers will certainly wish to employ sales people, and these issuers will need to undertake their own research on their own behalf in preparing documentation for prospective buyers,” said the report.

3. Everyone has been selling too hard

There’s been a wide-spread ‘bias towards action’ when it comes to equity investment from everyone involved in the process, says the report. Traders, market makers, investment bankers, company executives and analysts all have interests in spurring market activity, it says, even if doesn’t benefit the company in the long-term.

“Many people in the financial services industry who claim to be in the business of providing advice are in fact in the business of making sales,” says Kay.

This, and the fact that issuance has become so expensive, is prompting companies to look for alternatives: “This disenchantment is reflected in their behaviour. Some companies have gone private: many companies are unwilling to list: alternative means of obtaining finance, such as private equity and debt, have become more popular.”

4. Asset management pay needs to be shaken-up

Pay and bonuses in the asset management sector has so far avoided too much regulatory scrutiny. Most fall under the tier four category of the FSA remuneration code – aside from the large firms and those in subsidiaries of large financial institutions – and therefore are not subject to onerous deferral schedules.

However, Kay’s report recommends that asset management remuneration is tied to the “interests and timescales of their clients”, rather than the performance of a fund or company. “A long-term performance incentive should be provided in the form of an interest in the fund (either directly or via the firm) to be held at least until the manager is no longer responsible for that fund,” he says.

5. Large bonuses, in any form, have an “undesirable” effect on the City

Bonuses have become much more complex, but this doesn’t necessarily solve the problem of the “misalignment of incentives” or the that variable comp influences behaviour, he says.

“Bonuses for politicians related to the growth of GDP, or for surgeons based on the survival rate of patients, or for actors based on the number of curtain calls, would affect behaviour,” he says. “But not generally in desirable ways: the result would be to focus attention on short-term metrics which would frequently conflict with the long-term goals we would expect those engaged in complex tasks to pursue. Encouragement of short term behaviour is inherent in any pay structure in which performance bonuses constitute a substantial fraction of total remuneration.”

6. Warren Buffet is a model for asset managers to aspire to

Buffet’s approach should “represent a good starting point for any discussion of good practice in asset management”. Namely:

• Selection of a comparatively small portfolio of businesses, based primarily on the characteristics of the company rather than the cheapness of the stock.

• Very long holding periods.

• Stakes in the company of sufficient size to be capable of a (rarely exercised) influence on management succession and strategy.