Forgive the average investor who seems confused. After a savage 2008 that slashed portfolio values, prices are creeping up. But markets and investors alike remain unsettled. Pitched debates in global financial capitals consider systemic market reforms designed to reduce the possibility of similar market crises in the future.
Diagnoses come more easily than prescriptions: Borrowers should have disclosed more to lenders; lenders should have required more of borrowers. Investment bankers should have been less opaque in repackaging and distributing risk. Boards of directors should have been more alert to mounting risks. Credit ratings agencies should have been more objective and expert in assessing potential for default. Investors should have been more willing to conduct due diligence rather than rely on others' assessments. Central banks should have seen bubbles developing and acted to cool down markets. And so on.
It isn't just average investors who are perplexed and concerned. Every year, CFA Institute polls its membership of professional investors in key markets across the globe as to their perceptions of the integrity of market structures and participants. Although the 2010 Financial Market Integrity survey suggests an upswing in positive perceptions relative to the depths of the crisis, there is still substantial room for improvement. Perceptions of market integrity figure prominently in the level of confidence that investors have, which in turn affects the premium investors' demand for the risks they assume. As confidence is shaken, the cost of capital to governments and corporations rises commensurate with this risk premium, potentially stalling renewed economic vitality.
The breadth and magnitude of the crisis has inspired reform efforts in regulatory agencies and legislative chambers worldwide. The usual political divides inform these debates: Either we are in danger of choking the spirit of free enterprise with needless interventions that create unintended consequences, or we have a singular opportunity to correct the wrongs of the past by prescribing appropriate conduct and rules for market participants that close regulatory gaps, enforce consumer protection, and enhance transparency. Because the crisis transcended national borders, political solutions must also synchronize regionally (as in the European Union) and globally. The risk of regulatory arbitrage, in which jurisdictions friendly to specific interests associated with a transaction attract business at the expense of those with more comprehensive restrictions, sets reformist instincts and economic priorities in opposition.
Investors need not be overly cynical to doubt the potential for political solutions to the issues at hand. As a group, investors are diffuse and differentiated, with little ability to coalesce forcefully and inject a unified voice in the public policy arena. Trade groups do an admirable job of advancing their constituents' interests, so that banks, brokerages, financial planners, and asset manager firms among others all have effective advocates for their commercial interests. To the extent that investor interests coincide with the commercial interests of those who serve them, then these advocacy voices can serve a larger constructive purpose as well.
Inevitably, however, there is not perfect overlap between proprietary interests and those of investors. There are structural features of the global capital markets system that pit investors' objectives for return on their capital against the profit motives of the firms ready to advise and serve them. This agency problem is not new, nor is it secret. More often than not, transparency has been the disinfectant of choice to neutralize the potentially toxic effects of agency conflicts of interest or misalignments of priorities. More often than not, a minimum level of disclosure has been mandated by relevant authorities, ranging from simplified retail investor documents such as U.S. mutual fund prospectus summaries or the proposed UCITS key investment information documents in Europe, to highly technical and arcane accounting and reporting requirements for public securities issuers from the International Accounting Standards Board and Financial Accounting Standards Board. And more often than not, savvy counsel and political pressure allow all parties to satisfy the letter of the law while still shaping the substance of the disclosure to suit proprietary interests. Even in an age of amazing technological innovation, the sheer volume and density of boilerplate can overwhelm analytic capacity.
Investors pinning their hopes on regulatory reform to finally define the optimum degree of transparency are destined to be disappointed. Politicians and the regulatory apparatus aren't especially well suited to judge the often technical issues at hand, but the larger challenge is that the system is organic, ever evolving with its environment. The best and brightest toil long hours to adapt to new mandates and requirements, and have an excellent track record of innovation to frustrate the best of intentions in favor of protection of commerce. The supreme irony, of course, is recognition that, as investors, this is precisely the behavior we would wish for from our portfolio companies.
What's required is a way to transform this organic survival instinct of the agents working with investors from something that is occasionally contrary to investor interests to something that is well aligned with customers' priorities. The linkage between investor interests and agent profitability needs to be durable, direct, and observable. It must be able to withstand the ups and downs of markets and not be a matter of convenience or opportunity; interference from other agents or market participants must be minimized; and investors must be able to assess for themselves the existence and health of the linkage.
Ethics is this essential linkage between agents and investors. It is far past time for ethical conduct to graduate from being a cost of doing business associated with compliance to assume a more prominent role as the foundation for an investment business. Agents must move beyond lip service to high-minded ideals and concepts, and transform their business models to make ethical conduct fundamental to every aspect of their work. Ethics must permeate every role, every transaction, every relationship, and transcend national boundaries and cultural customs, or investors will quickly discern this to be merely a marketing strategy and not a core aspect of business.
Defining ethics in a way that is substantive, meaningful and relevant is challenging. All too often, slogans substitute for systems: "putting clients first" is aiming in the right direction, but is ultimately unhelpful if it does not accompany a reengineering of business models, customs, and practices to fulfill the aspiration. There is no need for strict definitions that don't fit with every business model. Rather, ethical principles that speak to desired outcomes ought to be agreed to, with room for bespoke implementation that accounts for unique characteristics of each firm. In some markets, these principles might mirror fiduciary obligations required by law or regulation, placing client interests first always. In others, the principles might acknowledge inevitable conflicts of interest and clearly identify how the conflicts are to be managed and disclosed.
Investors and their agents are diverse in their composition and objectives, so different models for implementation of a business grounded in ethics are likely. Whatever the model in practice, investors need a clear view of how the principles are applied to actual relationships and transactions. This will require fresh thinking from agents about how transactions are structured, what information is disclosed, how competing client priorities are addressed, how proprietary risk management objectives affect customers, and how products and services are priced. Advancing client interests need not mean being unprofitable: To the contrary, as investors recognize and differentiate agents based on their commitment to ethics, revenue opportunities should accrue to those with the strongest commitments.
It is this transformation of ethics from grudging acceptance to becoming truly fundamental to the investment business that is elusive. Individual professionals are eager to differentiate themselves to clients and employers by committing to robust codes of conduct, as evidenced by the growing membership rolls of organizations like CFA Institute that have such an affirmation as a condition of membership. But at the firm level, there is a mix of trepidation and cynicism that has slowed widespread acceptance of a common set of meaningful ethical standards that clients perceive to add value. We have developed the Asset Manager Code of Professional Conduct in an attempt to jump-start the focus on ethics, and although a few hundred firms globally have publicly embraced the code, some of the anecdotal evidence gathered in our travels is not especially encouraging. Similar efforts by other groups have also met with lukewarm reception. "Ethics" still has a strong compliance connotation, with all of the attendant legal risks that makes it easy enough for cautious legal counsel to discourage "unnecessary" commitments.
This is deeply unfortunate, because the times call for a strong, real commitment to ethics in the global capital markets. Never in our generation has faith in markets and market participants been more in question. Those who counsel and serve investors on the basis of price and quality alone are relying on a model for business that is out of date. The experiences of the last two years have opened investors' eyes to a myriad of opportunities for erstwhile partners to have significant conflicts of interest. And while some conflicts are inevitable given agency relationships, all can be managed and disclosed in a way that offers investors the opportunity to assess risks and choose partners objectively.
Integrity in the capital markets is at a crossroads. Regulatory reform, however necessary, is unlikely to inspire entirely renewed confidence given the pain of the past years. Many of those who make it their business to serve investors have shown reluctance to embrace and invest in common standards of ethical conduct that are meaningful and transparent. It is up to investors to demand this new standard of doing business. Ironically, it is the commercial imperative that has failed investors by encouraging agents to subjugate investor interests in favor of their own; but it is the same commercial imperative that can motivate those who wish to do business with investors to demonstrate unambiguously their commitment to investor interests as the primary tenet of their enterprise.