Submission from the Investment Management Association (IMA) (S023)
1. Executive summary
1.1 The key points in our submission are as set out below.
· It is not necessarily a lack of professional standards that culminated in the financial crisis and the more recent banking scandals but more the changes to the structure of the banking sector and the underlying incentives over the last forty years (paragraphs 3.1 to 3.3).
· Investment banking now dominates the sector with more of a focus on transactions as opposed to relationship banking. Investment banks not only transact with their customers but also offer them advice and guidance meaning they are inherently conflicted (paragraphs 3.4 and 3.5). They also advise on mergers and acquisitions where a significant percentage of the fees are fixed and contingent upon the deal being finalised, thereby creating an incentive for them to steer a company’s management to complete it. There are a number of examples of acquisitions which destroyed rather than maximised value (paragraph 4.3).
· The underlying incentive structures within banks encourage risk taking. Traders and executives receive large payments for activities that focus on increasing profit in the short-term, as opposed to the long term return on assets and prudent management of leverage. Such activities often proved damaging to the bank (paragraphs 6.1 to 6.3).
· Derivatives have an important role in risk management, but are complicated and can pose risks to stability if proper controls are not in place. Whilst few consider derivatives caused the crisis, uncertainty about where the exposure to credit default swaps lay, arising from both the opacity of the market and the extent of interbank dealing and exposure, precipitated further loss of confidence. The OTC clearing regulation (EMIR) and MiFID’s proposals on moving more derivatives to trading venues address these concerns, but may over address them and burden certain clients, such as pension schemes, with unnecessary costs (paragraph 6.9).
· Shareholders or fund managers in acting as fiduciaries on behalf of clients, invest in companies in order to secure a return for their clients. Whilst the main asset managers are committed to good governance and engagement, as evidenced by the growing number of signatories to the Stewardship Code, it is now apparent that in the run up to the crisis, engagement did not necessarily achieve the desired results, highlighting its limitations and the fact that banks are a special case (paragraphs 6.14 To 6.22).
· The fact that current accounting requirements allow all changes in fair value to be taken to the profit and loss needs to be addressed in that it drives the belief that profit can be created without necessarily having to be converted into cash. This reporting of temporary value changes as income impinges on the concept of prudence and results in the payment of remuneration and dividends out of profits that are not only unrealised but unrealisable. It also potentially misrepresents information when those changes have to be reversed in subsequent periods (paragraphs 6.31 to 6.33).
· We supported proposals in the final report of the Independent Commission on Banking that a bank’s retail operations should be ring fenced. However, in view of recent developments, the question needs to be asked whether this goes far enough in that certain of our members consider there should be full separation (paragraph 6.11). In addition, Government did not adopt the report’s proposal that derivatives should be outside the ring fence in its White Paper in June which set out how it is proposing to implement the Commission’s recommendations. The subsequent identification of interest rate swap mis-selling adds weight to the importance of derivatives being outside the ring fence. Government should now review its position (paragraph 4.2).
2.1 IMA represents the asset management industry in the UK, which is responsible for the management of approximately £3.9 trillion of assets invested on behalf of clients globally. These include authorised investment funds, institutional funds (e.g. pensions and life funds), private client accounts and a wide range of pooled investment vehicles. The Annual IMA Asset Management Survey shows that IMA members manage holdings amounting to about 34% of the domestic equity market.
2.2 In managing assets for both retail and institutional investors, IMA members are impacted by banks as investors in securities both of the bank itself (debt and equity) or originated by the bank, such as asset-backed structures. As importantly, banks are key components of the sell-side (to which our members are a significant community of the buy-side) and integral to many payment and clearing systems.
2.3 Banks play a vital role in the economy in allocating funds from savers to borrowers, operating secure payment and clearing systems, safeguarding retail deposits, managing financial risks and providing specialised financial services. Given recent banking scandals and the banking failures that precipitated the 2007-2008 financial crisis, the establishment of the Parliamentary Commission on Banking Standards is welcome. However, in any final recommendations it is important that the Commission bears in mind that the UK’s leading position in the international financial services industry is not pre-ordained and needs to be fostered not squandered  . In addition, given the role of banks, any measures to address patent failings needs to consider any impact on credit provision to the real economy.
2.4 It is from these perspectives that we respond to this Call for Evidence.
3. To what extent are professional standards in UK banking absent or defective? How does this compare to (a) other leading markets (b) other professions and (c) the historic experience of the UK and its place in global markets?
3.1 IMA does not believe it is necessarily a lack of professional standards that has culminated in the financial crisis and the more recent scandals. We consider the present culture in banking reflects the structural changes over the last forty years and the underlying incentives.
3.2 The internationalisation of London started in the 1960s with arrival of the Euromarkets, followed by the floating of exchange rates and abolition of exchange controls. But it was essentially Big Bang in 1986, and the abolition of single capacity and permitting corporate membership of the Stock Exchange, that gave rise to the main changes. Whist Big Bang brought efficiencies in that it made trading simpler and cheaper, it allowed jobbers, brokers and investment banks to merge to form integrated banks. A further consequence was that the UK investment banks were no longer expected to be separate from the retail banks. Their need for capital to enable them to grow and compete with New York resulted in a series of takeovers, particularly by US banks, which at the time were still restricted by the Glass Steagall Act. This brought a more aggressive culture, dominated by investment banks with their higher remuneration structures  ,  ,  .
3.3 Nor was this just a UK phenomenon. Whilst in the US the 1933 Glass Steagall Act, which followed the Great Depression, required investment and retail banks to be separate, it was repealed in 1999 allowing US banks to merge and diversify. A number of commentators have stated that this was an underlying cause of the financial crisis  .
3.4 This domination by investment banks changed the focus from the old style long-term relationship banking to one more focused on transactions. Investment bank professionals issue, recommend, trade and "sell" securities for buy-side investors, asset managers, to "buy". They are remunerated by charging clients fees and commissions for services. The relationship is transactional and is close to a zero-sum game, i.e. one participant's gain or loss is balanced by the losses or gains of another. Moreover, in not only transacting with their customers but also offering advice and guidance, they are inherently conflicted.
3.5 This contrasts with the business model operated by the asset management industry: an asset manager’s clients’ money and assets are segregated from those of the firms, and the manager’s activities do not put their security at risk. In a bank, on the other hand, client funds are held on the balance sheet and used in the business. Moreover, asset managers are paid a percentage of the value of the assets they manage. This firmly aligns their interests with those of their clients. Unlike banks an asset manager has no incentive to over-trade as it would have an adverse impact on performance and revenues because of the costs involved.
4. What have been the consequences of the above for (a) consumers, both retail and wholesale, and (b) the economy as a whole?
4.1 The conflicts within banks have had consequences for consumers, both retail and wholesale. This manifested itself in the recent mis-selling of interest rate swaps and payment protection insurance.
4.2 In this context, the final report of the Independent Commission on Banking proposed that a bank’s retail operations should be ring fenced and that derivatives such as interest rate and currency hedges should be outside the ring fence  . This was not adopted when the Government issued its White Paper in June which set out how it is proposing to implement the Commission’s recommendations  . The subsequent identification of interest rate swap mis-selling adds weight to the need for derivatives to be outside the ring fence. Government should now review its position.
4.3 There have also been consequences for the wider economy. For example, in practice UK listed companies retain a corporate broker, now mainly integrated into the investment banks, to provide advice. They advise on mergers and acquisitions where a significant percentage of the fees paid are fixed and contingent upon the deal being completed. Thereby creating an incentive for the bank to steer a company’s management to finalise the deal. There are a number of examples of acquisitions which in the long-run destroyed rather than maximised value. See, for example, Chapter 1 of The Kay Review’s Final Report  .
5 What have been the consequences of any problems identified in question 1  for public trust and in, and expectations of, the banking sector?
5.1 As a result of the above, trust in the banking sector has been undermined. Trust is vital to the effective operation of the capital markets. If the intermediaries that make up those markets cannot be trusted to operate with integrity, it can have a corrosive effect on the system and impact the whole of the financial services sector.
6. What caused any problems in banking standards identified in question 1 ? The Commission requests that respondents consider the following general themes:
· The culture of banking, including the incentivisation of risk-taking
6.1 One of the main incentives that encourage risk taking is the underlying remuneration structures within banks. Traders and executives often receive large payments for activities that focus on increasing profit in the short-term, as opposed to the long term return on assets and prudent management of leverage, and which subsequently proved damaging to the bank concerned and in some cases to the wider economy. A Financial Services Authority (FSA) discussion paper accompanying t he Turner Review of 2009 stated:
"there is widespread concern that remuneration policies may have been a contributory factor to the market crisis. The policies in common use during the period leading up to the crisis, mainly but not exclusively in investment banking, tended to reward short-term revenue and profit targets. These gave staff incentives to pursue risky policies, for example by undertaking higher risk investments or activities which provided higher income in the short run despite exposing the institution to higher potential losses in the longer run. In any case, remuneration policies were running counter to sound risk management, in effect undermining systems that had been set up to control risk  ".
6.2 A House of Commons Treasury Committee report argued that: "cash bonuses awarded on the immediate results of a transaction and paid out instantly meant individuals often paid little or no regard to the overall long-term consequences and future profitability of those transactions  ".
6.3 There has been much progress on this. Investors are more proactive in relation to the listed sector generally. Across Europe there is now legislation on remuneration structures at banks and indeed all investment firms and the revised Capital Requirements Directive (CRD 4) may make this tougher.
· The impact of globalisation on standards and culture
6.4 The increasing interconnections between international financial markets have resulted in an increase in the number, size, and complexity of banking groups and their activities. Although this has brought efficiencies, it makes effective supervision difficult in the absence of international standards. For example, in the recent LIBOR setting scandal regulators in the US, the UK, Canada and Japan are examining possible collusion by as many as 20 banks and interbroker dealers. This globalisation could, in some instances, increase systemic risk whereby losses in one banking group affect the whole financial system.
· Global regulatory arbitrage
6.5 Conduct is regulated on a host country basis and prudential regulation on a home country basis.
6.6 A bank might tend to seek to locate in those jurisdictions where it can circumvent more onerous regulation and taxation. Given the international nature of banking, opportunities for regulatory arbitrage also arise through the restructuring of transactions, financial engineering and geographic relocation. This can be difficult to prevent but its prevalence can be limited by closing the most obvious loopholes. The Financial Stability Board’s work on shadow banking has relevance here and it must be likely the G20 will return to the issue of non-compliant jurisdictions (offshore havens) in the near future.
· The impact of financial innovation and technological developments on standards and culture
6.7 The root causes of the financial crisis are well documented and centered on the growth in the securitisation of subprime mortgage debt, easy credit to finance speculation and a failure of the authorities to deal with financial innovation in a globalised world. Certain of these innovations had more impact than others.
6.8 Securitisation has been a very useful tool for more efficient intermediation across a wide range of assets, enabling investors to spread their risk and giving readier access to investment capital. But in its most extreme manifestation – the off-balance sheet special investment vehicle – it introduced greater opacity for investors and ultimately became a significant source of instability. Similarly, it can lead to mismatches between a product’s apparent properties and the underlying reality, as with collateralised debt obligations. Again the Financial Stability Board is considering this as part of the shadow banking project.
6.9 Derivatives have long played an important role in risk management, as a planning tool for businesses and as a portfolio management tool for asset managers. The role of banks in developing ready means of accessing the benefits of derivatives has been key to their success. But derivatives are complicated instruments, and if proper controls are not in place they can pose risks to stability. In the event derivatives had little impact as a cause of the crisis in the mind of most commentators. But extended uncertainty about where exposure to credit default swaps lay, arising both from the opacity of the market and from the massive amount of interbank dealing and hence exposure, acted to precipitate further loss of confidence. The OTC clearing regulation (EMIR) and MiFID’s proposals on moving more derivatives to trading venues address these concerns, but may over address them and burden some clients, such as pension schemes, with unnecessary costs.
· Corporate structure, including the relationship between retail and investment banking
6.10 We set out under 3 above the structural changes in the banking sector in recent times. In this context, we consider one of the reasons banks have tended to undertake more risky activities is the fungibility of capital between investment banking and the less risky retail operations. Until the cost of capital is differentiated across the business, in effect the less risky business subsidises the riskier activities and banks continue to make mistaken assessments as to the risk/reward trade off of certain activities.
6.11 IMA supports the Independent Commission’s proposal for banks to ring-fence their retail operations. However, in view of recent developments, we consider the question needs to be asked as to whether it goes far enough in that certain of our members consider there should be full separation.
· The level and effectiveness of competition in both retail and wholesale markets, domestically and internationally, and its effects
6.12 Whilst competition in both retail and wholesale banking is important, we consider it may have been lacking in investment banking internationally, particularly as regards underwriting fees and fees for mergers and acquisitions. This has worsened since the financial crisis.
· Taxation, including the differences in treatment of debt and equity
6.13 A potential solution to the problem of excessive leverage that underlay the 2007-2008 financial crisis would be to address the asymmetric tax treatment of debt and equity. If banks could no longer deduct the interest they pay for debt financing then they would be likely to issue more equity. Bank lending would fall as companies would be less inclined to borrow and there would be a shift to other means of financing, for example, venture capital. However, to be effective, for the reason stated in 6.6 and global arbitrage, any such change needs to be international.
The Commission requests that respondents consider weaknesses in the following somewhat more specific areas:
· The role of shareholders and particularly institutional shareholders
6.14 It is important to understand that the primary role of shareholders or fund managers is to act as fiduciaries on behalf of clients. They invest in companies in order to secure a return for their clients. If they have concerns about an investee company there are two broad ways by which they exercise discipline: by selling shares or engaging with management and boards.
6.15 From about 2005, a number of active investment managers concluded that the strategies being followed by many banks were unsustainable, and that they should not keep their clients invested in the sector. The resulting sales of shares were likely to have been one factor in the underperformance of the banking sector relative to the market as a whole, which was by some 9% in 2005. This meant that they were not able to engage with the banks concerned.
6.16 Others that were not in a position to sell their shares, for example, those running index funds or with mandates from pension fund clients which did not allow them to depart very far from the index, began to express concerns to some bank boards about strategic direction, and stepped up the amount of engagement they undertook.
6.17 IMA has been a long-standing supporter of the stewardship agenda. We firmly believe that many clients of asset managers expect them to take their stewardship responsibilities seriously when they are delegated to the manager, and that managers should and do respond to this. We set out in the Annex how this stewardship role has been transformed in the last decade. However, it is now apparent that in the run up to the crisis this engagement did not achieve the desired results, highlighting the limits on what engagement can achieve and the fact that banks are a special case.
6.18 Fund managers are restricted in terms of the information that is made available to them. They do not have insider status and are not privy to the same information as the executive or indeed the non-executive directors. In many instances, it is now apparent that bank boards and management failed to appreciate fully the risks on their balance sheets, thus, fund managers could not have been expected to either; this was not a problem which could have been avoided by better engagement
6.19 UK fund managers typically have relatively small holdings, this is particularly the case with the large banks. Indeed, as noted in our opening paragraph, the UK fund management industry only accounts for a third of all UK equities. However, particularly given the lower propensity for non–UK shareholders to vote at general meetings, a manageable group of UK shareholders could together constitute a significant proportion of those voting on any poll.
6.20 But there are concerns that acting collectively with like-minded investors to bring pressure to bear on management could trigger issues of insider trading, changes of control, and industry collusion and "the concert party" rules. The FSA has issued guidance and the Takeover Panel a Practice Statement to help allay these and facilitate engagement. However, there are still concerns as to whether collective shareholder action in relation to banks and other financial institutions are caught by the Acquisitions Directive  which has been implemented across the EU.
6.21 This requires regulatory approval before an investor and those acting in concert acquire a direct or indirect "qualifying holding" in a bank, investment firm or insurance company (broadly speaking a holding of 10 per cent or more). We understand that the FSA’s procedures do not envisage such approvals and there are concerns that the process to be followed and time taken would be an impediment to collective engagement. To address these concerns, it would be necessary to have some clarification that the Directive’s provisions are not triggered by an ad hoc agreement or understanding to vote together on a particular issue. In addition, because UK listed banks and insurers often also own regulated subsidiaries in other EU countries, the Level 3 Committees (or the European Commission) would need to confirm this understanding if shareholders are going to feel comfortable relying on any UK specific guidance.
6.22 In conclusion, there are limitations in what engagement can achieve – asset managers do not run companies; they do not set strategy nor are they insiders, in that they only have access to information that is available to the market as a whole. Managers compensate for such information asymmetries by diversifying their portfolio construction. Nevertheless the main asset managers are committed to good governance and engagement as evidenced by the growing number of signatories to the FRC’s Stewardship Code  . Thus although it is still relatively new, the Code is working and should be given time to take effect.
· Creditor discipline and incentives
6.23 A number of holders of credit instruments seek to exercise discipline over and engage with the issuers of those instruments. However, they do not have the same rights as holders of equity who as providers of the risk capital and bearers of residual risk can, for example, table resolutions at meetings, requisition meetings and vote their shares. Thus creditors’ effectiveness is more limited and key creditors will tend to manage their exposures by taking collateral. The effect of collateralization is to substitute the credit risk of the issuer of the collateral for that of the counterparty to the transaction. Moreover, following the collapse of Lehmann, bank bond issues have been guaranteed by EU and US Governments and more widely.
6.24 We consider the role of collateral remains insufficiently discussed. It leads to asset encumbrance and the FSA and others are addressing the liquidity impacts from that. But it also reduces the exposure large banks have to each other. Whilst this nominally reduces risk, it also eliminates the extent to which one bank has concern for what another is doing that might endanger its credit worthiness. In other words the very parties who might impose market discipline upon one another and have the capability to do so, are in fact much less concerned than might be expected. In addition, the need to pledge more and more collateral as a collapse approaches can hasten the end of a failing bank. It is to be hoped recovery and resolution plans may address some of these impacts.
· Corporate governance, including the role of non-executive directors, the compliance function, internal audit and controls and remuneration incentives at all levels
6.25 Whilst not a root cause of the financial crisis, there were clearly failings in banks’ governance and at times investors’ scrutiny and challenge to banks’ strategy. These were largely failures in execution rather than the corporate governance framework and the "comply or explain" regime. They did not cause the crisis nor would changes have prevented it but the experience prompted an examination of the framework to make it more effective. Sir David Walker issued his report in November 2009 on the governance of banks and other financial institutions which required specific initiatives, particularly by the FRC and FSA  . For many of the recommendations it is too early to assess their impact.
6.26 The FRC implemented those recommendations for listed companies in revising the Corporate Governance Code for years beginning on or after 29 June 2010. Others were implemented through its Guidance on Board Effectiveness of March 2010. The FRC also published the Stewardship Code in July 2010 and the FSA introduced a requirement that UK authorised asset managers report whether or not they apply it  . The FRC has recently consulted on further amendments to the UK Corporate Governance and Stewardship Codes. As noted in paragraph 6.22, these Codes should be given time to take effect before any further initiatives are considered in this area.
6.27 That said, one issue highlighted by the financial crisis was that non-executives were not necessarily performing an effective oversight role. It is vital that banks have high quality non-executives that are committed to ensuring they are run effectively and there is a need to increase the pool of talent and experience. Thus many consider NEDs should have fewer posts and be more involved in the companies on whose boards they sit.
6.28 On the issue of remuneration, the FSA has set out clear principles in its Remuneration Code which applies to the largest banks, building societies and broker dealers and investment firms, and requires them to apply ‘remuneration policies, practices and procedures that are consistent with and promote effective risk management’. Thus remuneration has to be aligned with the risks of the firm and Code Staff pay has to be disclosed. BIS is also looking to improve transparency around Executive Directors’ pay for the listed sector and give shareholders more power with a binding vote on pay policies every three years.
· Recruitment and retention
6.29 This aspect of the call for evidence is outside IMA’s remit.
· Arrangements for whistle-blowing
6.30 This aspect of the call for evidence is outside IMA’s remit.
· External audit and accounting standards
6.31 There are certain issues with accounting requirements that need to be addressed. First, mark to market accounting. Many instruments in the trading book have no alternative but to be marked to market, in that values at historical cost would reflect an arbitrary moment in time when the assets were initially recognised and make accounts less comparable. However, under current requirements all changes in fair value are taken to the profit and loss. This drives the belief that profit can be created without necessarily having to be converted into cash. We particularly have concerns when fair value is applied to holdings:
· that are so large that they could not be realised at the screen price;
· when extraneous factors exaggerate the volatility of the market price; and
· where there is no market in that they are marked to model inevitably adding to complexity and problems around the reliability of the model.
6.32 This reporting of temporary value changes as income impinges on the concept of prudence and results in the payment of remuneration and dividends out of profits that are not only unrealised but unrealisable. It also potentially misrepresents information when those changes have to be reversed in subsequent periods.
6.33 The Turner Review noted: "in the trading books a mark-to-market approach means that irrational exuberance in asset prices can feed through to high published profits and perhaps bonuses, encouraging more irrational exuberance in a self-reinforcing fashion: when markets turn down, it can equally drive irrational despair. And at the total system level, the idea that values are realisable because observable in the market at a point in time is illusory. If all market participants attempt simultaneously to liquidate positions, markets which were previously reasonably liquid will become illiquid, and realisable values may, for all banks, be significantly lower than the published accounts suggested. While it is difficult to quantify the effect, it is a reasonable judgement that the application of fair value/mark-to-market accounting in trading books, played a significant role in driving the unsustainable upswing in credit security values in the years running up to 2007, and has exacerbated the downswing  ".
6.34 As regards the banking book, under the current "incurred loss" model banks can only recognise the implications of events that have already occurred when making provisions, such as failures to make interest or principal payments; and not probable future events. Thus in good years this produces low figures for loan loss provisions and boosts income. By not reflecting the average future loan losses, capital ratios are bolstered, lending capacity is increased, and higher bonuses paid. The IASB is addressing this and moving to an "expected loss" model, but this is not yet effective.
6.35 No one would doubt that there are difficulties in valuing banks’ financial assets, particularly highly complex financial instruments, as compared to the assets of a trading company. This makes it even more important that auditors err on the side of prudence when undertaking their work. But in recent times the regulators have been concerned as to whether auditors exercised sufficient professional scepticism.
6.36 Scepticism is particularly important when key areas of accounting and disclosure depend on management’s judgement. However, we are concerned that auditors sometimes focus too much on gathering and accepting evidence to support management’s assertions, for example whether management’s valuations meet the requirements of accounting standards, and do not challenge enough.
6.37 This is borne out by the fact that there were significant variations in the numbers reported by different banks in relation to the same instruments, held for the same purpose and valued in accordance with the same accounting policies, even when the banks concerned had the same auditors. Moreover, the Audit Inspection Unit informed us that there were situations where conflicting judgments were accepted by the same firm for different clients in the same or similar industries.
6.38 A further area of concern relates to going concern. An example often cited by investors is the disclosures in the Royal Bank of Scotland’s accounts for the year ended 31 December 2007 which were signed off on 27 February 2008 but gave no indication that there could be future financing problems and had an unqualified audit report. However, as soon as April 2008 there were rumours that the bank was going to have to go to the market for additional financing. The refinancing of some £12 billion by way of one of the largest rights issues ever was completed in June.
6.39 Although some will argue that the auditors’ role is to express a view on historic figures and the subsequent refinancing was a post balance sheet event that could not have been predicted at the time, the uncertainties were such that we consider questions should have been asked. Moreover, from evidence given to the House of Lords, we understand that late in 2008, auditors received assurances from HM Treasury that Government would act to support the banks  . This was not transparent to investors.
6.40 The Sharman Panel of Inquiry, established by the FRC to consider going concern published its final recommendations in June  . Whilst it concluded that a special going concern disclosure regime was not necessary for banks, the report recommended that "the FRC should clarify that a conclusion that a bank is or would be reliant, in stressed circumstances, on access to liquidity support from central banks that is reasonably assured, does not necessarily mean that the bank is not a going concern or that material uncertainty disclosures or an auditor’s emphasis of matter paragraph are required".
· The regulatory and supervisory approach, culture and accountability
6.41 As an association that represents the asset management industry, we have no direct experience of this in relation to banks and are unable to comment.
· The corporate legal framework and general criminal law
6.42 In the FSA’s Report into the failure of the The Royal Bank of Scotland  , the Chairman argued that there may be a case for changing the personal risk return trade-off for bank executives and suggested a 'strict liability" regime for bank executives and directors for the adverse consequences of poor decisions or an automatic incentives based approach.
6.43 IMA considers a robust incentives based approach where rewards are based on long-term performance and where clawback is allowed and used, where appropriate, is the way forward.
6.44 FSA already has extensive powers to take action against directors of regulated businesses. However, we do not support a strict liability regime where penalties are imposed without establishing fault. This would discourage many able applicants from seeking appointment and could be considered unjust, and therefore open to legal challenge. But we would welcome stronger sanctions for those guilty of misdemeanours .
7 What can and should be done to address any weaknesses identified? To what extent are such weaknesses subject to remedial corporate, regulatory or legislative action, domestically or internationally?
7.1 As noted in paragraph 6.11, IMA supported the proposals in the final report of the Independent Commission on Banking that a bank’s retail operations should be ring fenced. However, in view of recent developments, questions need to be asked as to whether this now goes far enough in that certain of our members consider there should be full separation.
7.2 Many of the issues this Commission has raised are governed by EU legislation which governs a wide range of financial institutions including banks, which will principally be credit institutions authorised and regulated under the Second Banking Co-Ordination Directive (2BCD) and the revised CRD 4. Other banks will be regulated under Solvency II. We would not expect any bank headquartered in the UK to be outwith European regulation. What the UK may propose in legislation may be extremely limited. Even supervisory authorities can be expected more and more to follow harmonised approaches from the European Supervisory Authorities.
7.3 Moreover, the role of good governance in banks continues to be high on the international and domestic agenda. The Basel Committee on Banking Supervision issued a set of principles in October 2010 for enhancing sound corporate governance practices in banks. Basel III is being implemented, in broad terms, by CRD 4 which contains requirements on corporate governance for all banks, as well as other financial institutions such as MiFID portfolio managers. In April 2011, the European Commission published its Green paper on an EU Corporate Governance Framework an action plan on which is expected this autumn. In the UK, the Financial Reporting Council updated the UK Corporate Governance Code in May 2010 and in July 2010, published the UK Stewardship Code. It has just completed a consultation on further amendments to both of these Codes.
8 Are the changes already proposed by (a) the Government, (b) regulators and (c) the industry sufficient? Respondents may wish to refer to the Financial Services Bill and the Government's proposals for the Banking Reform Bill. They may also wish to refer to proposals by the Bank of England and the Financial Services Authority on how the Financial Policy Committee, Prudential Regulation Authority and Financial Conduct Authority will operate in practice.
8.1 In addition to comments elsewhere in this response, IMA welcomes reforms that aim to enhance the protection of retail consumers of financial services and give a greater role to the central bank in relation to the promotion of financial stability. Thus the Bank of England, as the lender of last resort, is to assume responsibility as the Prudential Regulatory Authority and has an incentive to protect the taxpayer against any abuses of the insurance it provides.
9 What other matters should the Commission take into account?
9.1 The Commission may wish to consider seeking to address mis-selling and the sales-based culture. A possible solution would be if banks ceased paying sales commission to frontline staff and instead lined bonuses to levels of customer satisfaction, the fair treatment of consumers, and resolution of complaints.
Memorandum by the Investment Management Association
The Development of Stewardship
In 2002, investors gave new impetus to stewardship and the Institutional Shareholders’ Committee (ISC  ), whose members, including IMA, represent virtually all UK institutional investors, issued the Statement of Principles  . This was the first comprehensive statement of best practice governing the responsibilities of institutional investors in relation to the companies in which they invest on behalf of the ultimate owners.
IMA benchmarked the industry’s adherence to the Statement of Principles through regular surveys. Starting in 2003, these clearly demonstrated that engagement was evolving and becoming more transparent. The last survey to 30 June 2008 showed that 32 asset managers that managed equities amounting to 32 per cent of the UK market actively engaged, voted their UK shares, and increasingly published their votes  .
Nevertheless, institutional investors recognised that in the run up to the financial crisis there were failings in their scrutiny and challenge to banks’ strategy and excesses, and that they needed to address this. The ISC took steps to do so and reissued the Statement of Principles as a Code in November 2009, modifying it to seek to improve the dialogue between institutional investors and companies.
The Government at the time wrote to the FRC asking it to adopt the Code and, following a public consultation, the FRC issued it as the Stewardship Code in July 2010. In December 2010, the FSA made it a requirement that authorised asset managers disclose publicly their commitment to the Code or their alternative business model. This aimed to ensure that those that appoint asset managers are aware of how a manager exercises its stewardship responsibilities, if any. The Code also expects those that commit to it to report to their clients/beneficiaries on how they have exercised their responsibilities and to have a public policy on voting disclosure.
It is important that this transparency is supported by practice. IMA undertook to look at the activities that underlie it and to see what impact the Code has over time. We published our first report last year our second report in June 2012. The latest report summarises the responses to a questionnaire that was sent to all 173 signatories that had committed to the Code as at 30 September 2011. 83 institutions responded: 58 Asset Managers; 20 Asset Owners; and five Service Providers. The Managers that responded managed £774 billion of UK equities, representing 40 per cent of the UK market, and the Owners owned £62 billion.
The latest report clearly demonstrates progress. For example:
· as at 30 September 2011 173 institutional investors had committed to the Code up from 80 as at 30 September 2010;
· all of the 2011 respondents now have complete policy statements on how they exercise their stewardship responsibilities whereas in 2010, six respondents only had a statement of their intention to produce one;
· in 2011, more of the 2010 respondents have client mandates that refer to stewardship;
· the 2010 respondents increased their resources responsible for stewardship by 4 per cent in 2011;
· the proportion of votes cast increased in all markets in 2011; and
· a greater proportion of respondents publicly disclosed their voting records - 73.4 per cent in 2011 as compared to 69.0 per cent in 2010.
In conclusion, although it is still relatively new the Stewardship Code is working in that more UK institutional investors are committing to stewardship and are increasingly transparent about doing so. We consider that this initiative should be given more time to take effect.
Nevertheless, it is now apparent that in the run up to the crisis this engagement did not achieve the desired results, highlighting the limits on what engagement can achieve.
24 August 2012
 See IMA, Asset Management in the UK, 2009-2010, pp 77-81.
 Financial Services Authority Conduct of Business Rule 2.2.3, which was effective from 6 December 2010.
 http://www.fsa.gov.uk/pubs/other/turner_review.pdf , page 65.
 http://www.publications.parliament.uk/pa/ld201011/ldselect/ldeconaf/119/11909.htm , paragraphs 149 to 154
 The members of the ISC we re: the Association of British Insurers; the Association of Investment Companies; the National Association of Pension Funds; and the Investment Management Association . In 2010 this was reconstituted as the Institutional Investor Committee made up of the Assoc iation of British Insurers; the National Association of Pension Funds; and the Investment Management Association