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3rd Annual Forum on Responsible Investing

Learning From the Financial Market Crisis

Keith Johnson, Chair, Reinhart Institutional Investor Services

New York City, January 12, 2009

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2« We’re still dancing »

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The Morning After

• Lehman Brothers • AIG• Fannie Mae/Freddie Mac• Bear Stearns• Merrill Lynch• Wachovia• Northern Rock• General Motors• Chrysler• Bernard Madoff

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The wasted decade….S&P 500 from 1998-2008

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Increasing Velocity of Financial Crises

• 1987 Market Crash• 1989 S&L Debacle• 1994 Mexican Peso Crisis• 1997 Asian Financial Meltdown• 2001 Dot Com Bust• 2007 Subprime Disaster

2007 Subprime

2001 Dot com

1987 Crash

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Sunday 21 September 2008

“ … once we stabilize the markets, we then have to take actions to make sure this doesn't happen

again. … we have a regulatory system that is

broken. It's outdated. It's outmoded. It doesn't fit the world we

live in.” Hank Paulson, US Treasury Secretary

Former CEO of Goldman Sachs

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Network for Sustainable Financial Markets – A Different Approach

• International, non-partisan network of individuals• Currently participants from ten different markets • Finance professionals, academics & others • Interest in long-term health and sustainability of

markets• Foster inter-disciplinary collaboration on

research, solutions and advocacy• Focused on systemic and fundamental issues

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Robert AdamsonKeith

AmbachtsheerRob Bauer

Adrian BerendtAnn Byrne

Mark CampanaleGreg ChipmanCecile ChuretGordon Clark

Ronald B. DavisStephen DavisPaul DickinsonHans Dijkstra

Ralf FrankMurray Gold

Jack GrayDanyelle Guyatt

Frank Jan de Graaf

Stirling HabbittsMathew Haigh

Jonathan HaywardKeith L. Johnson

Sean KidneyEric Knight

Janelle Knox-HayesFloris

LambrechtsenJinyan Li

Steve LydenbergMichael MainelliFranz MaritschHeleen MeesPaul Moxey

Mike MusuracaRobert A. G. MonksLouise O’HalloranJames O’LoughlinMatthew Orsagh

Vasudec PalladamFrank Partnoy

Avinash PersaudPoonman Puri

Amin RajanBenjamin Richardson

Nick Robins William Russell-Smith

Janis SarraHoward ShermanPenny Sheperd

Dan SiddyMichael Siebecker

Ken SewartNicholas Taylor

Raj ThamotheramJeroen TielmanMark van Clieaf

Ed WaitzerRobert WalkerSteve Waygood

Helen WildsmithCynthia Williams

Peer Zumbansen … and more

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• Excessive leverage/debt

• Inadequate risk management

• Flawed and excessive incentive structures

• Conflicts of interest endemic to financial system

• Vicious circles of short-termism at all levels

• Separation of risk from product creation and distribution

• Segmented regulators with inadequate resources and lack of will

• Politics and ideology trump knowledge and policy

System is as prone to periodic crises and misallocation of capital as it was before sub-prime.

Some Key Lessons from the

Market Crisis

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The NSFM Principles Lead to Solutions

7. Promote a coordinated global approach

6. Reduce conflicts of interest through smarter alignment of rewards

5. Improve governance at financial institutions

4. Improve market participants accountability for their actions

3. Balance short-term and long-term interests

2. Identify and value hidden risks and opportunities

1. Purpose of markets is to efficiently create sustainable value

This is what NSFM participants have signed up to…

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Efficient resource allocation

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Beyond economic measures

“Gross national [or domestic] product measures neither the health of our

children, the quality of their education, nor the joy of their play […]

It is indifferent to the decency of our factories and the safety of our streets

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It measures everything in short, except that which makes life worth living […]”

Robert Kennedy 1968 12

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• Fiduciary duty and long term investing– Comments to OECD on Pension Fund Governance

Best Practices– Modernizing Pension Fund Legal Standards

Consultation Paper• Regulatory reform white papers

– Survey of financial professionals on who is to blame for the crisis

– Credit Derivatives Market Design Consultation Paper• Executive remuneration reform • Climate change and long-term investors

Currently, the active NSFM working groups…

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Climate change is the greatest and widest-ranging market failure ever  

Stern Report, 2007

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Identify, value & recognize costs offloaded to society

carbon externalised carbon internalised

95%

5%

$4.7 trillion of carbon damage to real economy per year

Source: Nick Robins, NSFM

Solution?

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Fiduciary duty & long-term investing

problems

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“The obsession with short-term results by investors, asset management firms, and corporate managers collectively leads to the unintended consequences of destroying long-term value, decreasing market efficiency, reducing investment returns and impeding efforts to strengthen corporate governance.”CFA Centre for Market Integrity & Business Roundtable Institute for Corporate Ethics, July 2006

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Short-Termism is a Systemic Cause of Value Destruction

“. . . It is shocking that the majority of firms are willing to sacrifice long-run economic value in order to deliver short-run earnings. Companies do this in response to intense pressure from the market to meet expectations. . . . we assert that the amount of value destroyed by firms striving to hit earnings targets exceeds the value lost in these high profile fraud cases. . . . What is worse is that these actions are not even considered to be a ‘problem’ by many CFOs.”

Value Destruction and Financial Reporting Decisions, John Graham et al., Duke University, September 2006

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So, do we need more regulations?

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NSFM/AQ Research Survey of Investment Professionals

Who was to blame for the financial crisis?• Bank leaders and their boards: 21%• Shareholders/fund managers: 19%• Politicians and regulators: 14%• Central bankers: 10%• Asset owners: 9%• Investment analysts: 9%• Hedge fund investors: 7%• Accountants: 6%• End customers: 6%Only 7% think solutions should only come from government

Source: http://www.aqresearch.com

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• Mainstream investment and responsible investment professionals both need to think creatively!

• Both face same challenges – going beyond their current products, competencies & business models

• Both face organisational/group think constraints• Projects like NSFM could help introduce new approaches

A challenge to you! Find an important issue you know the responsible investment community doesn't really have a good enough answer to, which you are really concerned about, and join/start a working group!

For financial markets to change, we need to change together

www.sustainablefinancialmarkets.net

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