At root, the failures that caused the current credit crisis can’t be solved by the central banks alone. A lack of accountability, responsibility and transparency have broken the trust investors and traders had in capital market securities.

Valuations are suspect. Balance sheets obscure. Capital adequacy under question.

As we argue in our book, The New Capitalists, capital markets can serve us well. But if they lack accountability and responsibility, that is a toxic mixture.

So, what happened, and what is to be done about it?

In the past, when a bank made a loan, it owned the loan. It was therefore concerned that its customers were fully credit worthy. However, regulations allowed banks to make more loans if they were held in a special purpose vehicle, off the bank’s balance sheet. To take advantage of this, many loans were made (originated) by individuals, banks and others, then packaged up and sold on to “the market”.

This process of disintermediation has meant that banks had less need to check credit worthiness. Incentives were simply to write more loans, take a fee, and sell on the loan. In order to be assured that loans were credit worthy, the market therefore passed on accountability and responsibility for the credit worthiness to Credit Rating Agencies. These are paid for by the issuer of the loan, and therefore cannot avoid concern about conflict of interest.

Further, accounting standards had increasingly adopted the “fair value” rule, to constructing a balance sheet. Old principles of prudence, such as “the lower of cost or net realisable value”, can often be sacrificed by adherence to such rules, especially where there is no market for the securities in question.

Holders of these credits behaved as traders, just the way Keynes described them. Traders bet against each other. They seek “out performance” for themselves, with little concern for the performance of the market overall, even though it is the market which will ultimately pay our pensions, and out performance is a zero sum game.

These problems will only be solved by a greater focus on ownership, accountability, responsibility, and transparency.

There would be value in reviewing banking regulation and accounting, particularly in regard to off-balance sheet finance.

There should be standards for Credit Rating Agencies (CRAs) to ensure their independence.

We could slow the dash to International Financial Reporting Standards, and their focus on fair value.

We could review the role of institutional investors as owners. They need to seek a high market return just as assiduously as they seek out performance, on all their investments.

We need constantly to return to the principles on which successful capital markets are based. It is on those principles that all our investments depend. It is only the participants, not the regulators, who together can ensure the accountability, responsibility, and transparency, we need.

There is an old economics dilemma, known as the “tragedy of the commons”; that we pay too little attention to things which no one individual owns. Every pension trustee, every holder of an insurance policy, every investor, direct or indirect, depends on the trustworthiness of capital markets. We need to play our part in ensuring that trust is merited.

* David Pitt-Watson is chair of Hermes equity ownership services

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Tags: capital markets, capital market trust, david pitt-watson, central banks, hermes, credit crunch,

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