Con Keating argues the concept of prudence must become a mainstay in the risk management of long-term investment in order to avoid procyclicality.
This summer saw the publication by the Bank of England of an interesting report by a working party on “Procyclicality and structural trends in investment allocation by insurance companies and pension funds”.
It is a veritable mine of data and information. In common with earlier work by Boon, Briere and Rigot1, it found evidence of declining allocations to risky assets by these institutions, but no strong evidence of procyclical behaviour during the crisis. Boon, Briere and Rigot found evidence of a strong role for regulation in this de-risking trend, while the Bank report makes much of the forbearance exhibited by insurance and pension regulators and their widespread relaxation of the rules during the crisis.
As it is hardly prudent, it is difficult to believe that any pension scheme could or should be managed on the basis that the rules will be relaxed when they bind and require action – so we should expect de-risking to avoid the possibility of procyclical costs, and to the extent that de-risking has been undertaken less evident procyclicality in crisis. Interestingly, the concept of prudence gets scarcely a mention in the Bank report.
By contrast, a group of long-term investors (under the aegis of the Local Authority Pension Fund Forum) once more took the FRC to task over the issue of “true and fair”. This short response to the FRC2 begins by noting that: “Long-term shareholders have a strong interest in supporting a system of reporting that delivers a prudent view of companies’ capital position, incentivises long-term stewardship of invested capital, and promotes stable and sustainable economic growth.”
The problem with the IFRS is that they have abandoned prudence in favour of “neutrality”; a recent European Court of Justice ruling (State of Belgium versus GIMLE3) concludes that prudence underpins “true and fair”.
The LAPFF group asserts: “While the crisis had many contributory elements, the accounting rules played an insidious role.” The substantive issues here are the IFRS recognition of gains before they are realised and the lack of adequate provision for foreseeable losses.
The Bank paper does discuss herding among pension funds, but fails to place this in the wider context that mimicry across market participants can, when widespread, lead to catastrophic results and market panic. This has been investigated by, among others, Yaneer Bar Yam of the New England Complex Systems Institute at MIT4. To quote from his work: “The recent economic crisis and earlier large single-day panics were preceded by extended periods of high levels of market mimicry – direct evidence of uncertainty and nervousness, and of the comparatively weak influence of external news. High levels of mimicry can be a quite general indicator of the potential for self-organised crises.”
This immediately raises a question: How prudent is passive investment, institutionalised mimicry, in a macro financial stability context? Something is currently failing, badly – regulation is driving investors away from the asset allocations that the authorities would themselves like to see – and the problem lies with the risk management protocol – this needs to be broader than the static preventive approaches in use, and the precautionary principle seems a strong candidate.
The concept of prudence lies within the domain of the Precautionary Principle, which figures prominently in the world of sustainability, and is repeatedly advocated by officialdom.
Notwithstanding some criticisms, this is clearly the setting in which the risk management of long-term investment needs to be considered and it clearly merits much more discussion if the investment community is to respond to the exhortations to increase long-term investment.
Con Keating is head of research at BrightonRock Group
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