by Rebecca Fender, CFA
The financial industry today faces a crisis of confidence that threatens its future. Without trust, markets don't function properly and growth prospects are limited. So what can the financial industry do to change its trajectory? A panel at the 66th CFA Institute Annual Conference in Singapore, moderated by CFA Institute CEO John Rogers, CFA, provided some answers:
Investment professionals must truly believe that client interests come first — and act accordingly. As Mark Delaney, CFA, chief investment officer and deputy CEO of AustralianSuper, the pension fund, stated, "The first thing is that it's always someone else's money." He urged the audience to think about how they look after other people's money and what goals their clients need to achieve. As an industry, he observed, the investment profession has lost sight of that purpose and replaced it with self-interest.
Fred Hu, chairman of Primavera Capital Group, reinforced this point, saying the most important thing that the finance industry could do to restore trust is to minimize conflicts of interest and pursue high standards of integrity.
Aaron Low, CFA, principal of Lumen Advisors LLC, took this concept one step further, pointing out that a natural consequence of lack of trust is that the cost of due diligence will go up. Similarly, he said, we are seeing small funds get smaller and big funds get bigger; this concentration is a symptom of the underlying trust problem. In turn, this increases systemic risk — and, as Hu said, "Too big to fail is a universal problem; there are no country exceptions."
We need to identify and avoid conditions that foster systemic risk. Low noted that it is hard to figure out where risks will arise, but you have to look at the conditions in place. An environment rife with conflicts of interest provides an ideal setting for systemic risk to grow. He reasoned that few would have anticipated the extent of the impact of subprime debt or Greece on the markets, but with the right conditions in place any little thing could be the straw that breaks the camel's back.
Low went on to say that coordinated monetary policy is another major source of systemic risk. Through monetary policy, "we are pumping steroids into a very sick patient in the West and importing those steroids to Asia. If you give steroids to a healthy patient long enough he will die." In addition, Low said, "I fear this liquidity [in Asia] if it goes unchecked will give rise to other problems. We are seeing all kinds of asset bubbles in Asia, and real estate is at levels we've never seen before." This situation will create more principal/ agent problems and therefore lead to even greater instability. Conflicts of interest and systemic risk reinforce each other and create a downward spiral effect, he added.
Delaney contended that the combination of inappropriate financial innovation, leverage, and poor regulation set up the conditions for systemic risk. Rogers, for his part, challenged the audience of investment professionals to consider the role we should take as stewards of the industry to call out systemic risks, versus just profiting from the anticipation of problems.
Retirement plans need an overhaul. Delaney observed that books and theory are weak on the withdrawal phase of pensions and how to manage drawdowns given the demographics of aging populations. There have been unintended consequences of the democratization of pensions, he said, and we don't have many tools to address this. Additionally, when beneficiaries are put in charge of their own retirement without professional management, many behavioral challenges arise. Add in low interest rates and it makes the situation even worse. Delaney said we need to redefine risk: it is not volatility as much as the risk of running out of money.
Hu added that the traditional pay-as-you-go system isn't even sustainable in China. Some countries like Australia and Chile provide alternative models that other nations could learn from, but China has yet to put a suitable pension system in place.
Emerging markets offer hope, but reforms are needed. As an example, Hu explained that a key challenge for ongoing financial reform in China is to level the playing field so that small businesses and consumers have access to credit. The financial sector is not set up to support individuals in this way yet. China has surpassed the U.S. in demand for cars, but nearly all are paid for in cash. This is a hurdle to China's goal of domestic economic growth becoming more consumer-driven versus export-led.
Without transparency, all these efforts are futile. Low said that we as a financial industry have been "hiding behind a cloak of complexity." Delaney echoed this by describing the nature of financial products in this way: "The more complicated it is, the worse the outcome is likely to be." He also counseled investors to watch out for "knowledge imbalances," meaning that if you don't know enough about what you are buying "it always turns out to be a disaster."
The implications of the industry's challenges are many, and they affect us all. As Low said, "Is the world a better place for the next generation? I'm not sure it is." These are not academic exercises or efforts that will result in a basis point or two of additional return. The stakes are high, and if we are to use our expertise to change the future of finance for the better, the time to start is now.
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