Eva Srejber: Financial delegation - how do I keep a check on those managing
my money?
Speech by Ms Eva Srejber, First Deputy Governor of the Sveriges Riksbank, to the Swedish
Shareholders Association, Stockholm, 25 November 2003.
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Introduction
Let me begin by thanking you for the invitation to speak at the Swedish Shareholders Association.
During the time at my disposal I intend to discuss the issue of what opportunities we savers have to
ensure that our money is not used for purposes other than to improve our personal finances. This is a
problem that has dogged us for quite some time and it has risen to the surface once again with the
discussions on ownership of certain Swedish life insurance companies. What makes this question
particularly interesting for the representative of a central bank are the further complications that can
ensue if the general public loses confidence in those managing its savings. If this were to happen, it
would affect more than just the savers. There is a risk that we would all be affected in the form of
poorer economic growth. As confidence crises can arise in all forms of savings, regardless of whether
this is via normal bank accounts, through direct purchases of shares or deposits in funds, I shall
discuss the issue on a more general level and not focus on the present problems in the life insurance
companies.
Driving forces behind saving
The deregulation of the financial markets that began in Sweden during the 1980s signified major
changes for Swedish savers. Suddenly we had much greater rights to decide over our money
ourselves and to take many of the savings decisions that were previously a central government
monopoly. The rapid and innovative developments in the financial markets also gave savers greater
opportunity to choose different types of savings. It is not surprising that during this time we have also
seen a large increase in financial savings. The deregulation processes explain some of this. The tax
reforms and the return to a low-inflation economy are other explanatory factors. However, the
underlying trend is mainly due to demographic changes. As recently as in the 1980s, people invested
the greater part of their savings in real assets, such as housing and durable consumption goods, as
well as human capital, i.e. various forms of education. Since then, financial investments, whether in
bank accounts or in various types of securities, have taken up a larger part of people's savings. This
change can be broadly explained by people adapting their consumption and thereby their savings
according to different life phases. When they are young, their consumption usually exceeds their
income. This is when people start a family, get an education, buy cars and houses or apartments. To
cover all of this expenditure, most of us borrow money. As the years go by, incomes rise, enabling
people to reap the fruit of investments in human capital, while they have already made their major
investments. Their debts can now begin to be paid off and their financial savings can increase. One
conclusion is that the larger the percentage of young people in relation to older people, the larger the
savings in real assets. On the other hand, a country with a slightly older population has a relatively
large percentage of financial savings. This description applies quite well to Sweden. Bearing in mind
the need for change that population developments put onto the pension and welfare systems, it is also
reasonable to assume that private financial savings will need to increase further in the near future.
This is what will be required in future to be able to manage one's finances after retirement. I discussed
the link between this development and inflation in a speech I held on 19 November.
Confidence forms the foundation
When it comes to savings, most of us probably want to diversify as much as possible. Of course, we
want to receive a good return on our savings, but at a reasonable risk level. We have also become
more aware that it is net return, that is, the return after deductions for various charges, that determines
how much our savings are worth. The demand for well-diversified savings at a relatively low cost has
created the basis for the substantial expansion in passively-managed share index funds in recent
years. Investments in these funds reflect the development of a given index, which means that active
management becomes unnecessary. The fact that these funds have been so widely successful, at
least on more developed markets, can be seen in the BIS report on institutional asset management
presented last spring.1 As the report also shows, developments in the financial markets have opened
up more exotic markets and sectors for our savings. Active management is more common on these
markets, as the opportunities to pan for gold nuggets that will outperform the market average are
considered greater here.
This development has had great significance for the efficiency of the functions supplied by the
financial sector. Here I am thinking of the possibilities for risk management and conversion of savings
to risk capital for investment. The financial sector also has other important functions, but I will not be
discussing them today. Diversification, as I mentioned earlier, is one example of how households can
simply and relatively cheaply reduce risks in their savings. The increased confidence savers can feel
through the diversification offered by various savings companies increases the flow of capital from
savers to investors. As national boundaries are less distinct within the financial world, capital is able to
move to where it is most useful, whether this is in Sweden or elsewhere in the world.
Deregulation enables market forces to be utilised to a greater extent to allocate capital and manage
risks. Once a society has taken this step, it must take the further step of ensuring that individual savers
have confidence in the market actors. The possibility for the financial system to supply functions
important to the economy in an efficient manner is based on the existence of such confidence. A
glance in the rear-view mirror shows that this confidence cannot be taken for granted. What is
happening in the life insurance companies now is a good example of this. Although the crisis is fairly
limited, it clearly shows how fickle confidence can be. The amount of new savings in life insurance
companies has been declining for some time now, but the scandals at Skandia have further fuelled
savers' mistrust. According to a survey by Sifo printed in Göteborgs-Posten newspaper on
2 November, three-quarters of the Swedish public lost confidence in life insurance companies after
revelations of the scandals.
Herd behaviour causes problems
The risk of confidence problems arising in connection with financial delegation, that is to say, when I
put the management of my savings in the hands of someone else, cannot be ignored. This is largely
because all forms of financial delegation contain a potential conflict of interests. The person managing
my savings may have quite different interest from me.
One example is the herd behaviour observed among asset managers. To some extent, this is a
question of rational behaviour based on the assets earning money on the charges paid by savers. It is
important to be at least as good as the average to avoid losing the battle for savers' money.
Otherwise, it will be much more difficult to attract new savers. From this perspective, the cost of being
poorer than average weighs heavier than the gain of being better than average. It will then be rational
for asset managers to act in the same way as their counterparts. If everyone else buys IT shares, I as
an asset manager will also have to buy them to avoid deviating too much from the rest. The major
problem here is that this in turn could have a negative effect on the financial markets. It appears that
this is the case. Herd behaviour has been highlighted as one of several possible reasons for the most
recent stock market bubble and the ensuing crash.
Large fluctuations in the financial markets make savings less secure. Well-diversified savings, for
instance in a fund investing in both shares and debt securities, normally provides good protection
against changes in share prices and interest rates, and people are aware of this now. On the other
hand, it is less certain that they realise that the asset managers' behaviour in itself can contribute to
major fluctuations in the markets, which in turn makes well-diversified savings more risky than they
ought to be. If the incentives programmes used to motivate individual asset managers are based on
their success in relation to competitors, this can further reinforce negative herd behaviour.
These problems can be aggravated by the construction of the index against which many asset
managers are assessed. This is one aspect taken up in the BIS report I mentioned earlier. The
weights used to calculate a company's share in many of the most popular indices are based on the
company's market value. This tends to lead to overvalued companies being overrepresented in the
index. As asset managers' opportunities to deviate from the index by underweighting overvalued
companies is often very limited, the unavoidable result is that the manager may be forced to invest in
companies that are considered overvalued.
Naïve view of bonus programmes
The remuneration structure for managers of listed companies is another potential source of a conflict
of interests affecting savers. Linking senior management's incomes to the development of the share
price increases the probability that company management and shareholders will have the same
interests. Senior managers will concentrate on increasing the value of the company, as this will give
them higher income. The idea is that this will reduce the risk of senior managers occupying
themselves with business that will not benefit the development of the company. This also benefits
those who have invested their money in a savings company which has in turn invested in the
company. The whole idea is, of course, based on the share price also reflecting some form of
fundamentally expected change in value in the company.
However, the corporate scandals in recent years show that it was naïve to link the bonus solely to the
short-term development of the share price. This evidently gave less scrupulous senior managers an
incentive to try to affect the share price through creative accounting or through dubious dealings in an
attempt to affect the reported profits. If this type of bonus programme is to function, it will require much
more sophisticated systems than merely linking the bonus to temporary changes in the share price.
The bonus must be based on actual, sustainable improvements in the company's results and it must
have a ceiling. On the other hand, one can wonder why a good salary should not be considered
enough incentive to do a good job. Whatever the circumstances, it can be observed that there is
tremendous pressure from the general public and authorities to make changes. We should therefore
be able to assume that improvements will be made, to reduce the risk of senior managers acting in a
way detrimental to shareholders and those saving indirectly in the company's shares.
Ownership issue important but difficult
Many people have pointed to the increase in institutional savings as the culprit in the bonus drama.
The AP pension funds, the insurance companies and various types of asset management companies
have tried to avoid taking on an active ownership role as far as possible. The reason given is that
active ownership does not benefit savers. Active ownership costs money and also makes it more
difficult to withdraw from a company one is dissatisfied with. The institutions have said they prefer to
vote with their feet. If they are dissatisfied with a company, they quite simply sell their holdings in it.
One consequence of this reluctance to exercise active ownership has been that more power has been
transferred to company managers, who have been able to grant themselves unreasonable fringe
benefits.
The emergence of the institutional owner has also led to pronouncements about the advantages of the
old, traditional family ownership. Personally, however, I am not entirely convinced that this is the best
form of ownership. In Sweden this has meant that one owner has been able to control companies
despite a very small capital contribution, what is known as pyramiding. As is the case with excessively
powerful company managers, these owners can act in a way that does not benefit other shareholders.
In Sweden the desire to control corporate groups has probably often been a more important driving
force among some of the traditional owner families than an interest in increasing the worth of the
shares.
Personally, I believe that Sweden would benefit from more institutional investors electing to take an
interest in ownership issues and how to check on those managing our savings. This would reduce the
risk of expressions of avarice such as we have seen in ABB and Skandia. There are also signs that
some institutions have begun to think along these lines. For instance, a couple of the AP funds have
taken a fairly firm stand on ownership issues. However, it is important that we continue to discuss the
role of institutional owners.
A further potential conflict of interests can be found between shareholders and mutual fund
participants in the bank-owned investment fund companies. According to Swedish law, an investment
fund company shall be a limited liability company and act to maximise the value for shareholders. If
shareholders' interests and the interests of those contributing capital do not coincide, there are
grounds for a conflict. One example is when a bank-owned investment fund owns shares in a
company in which the bank in its turn has an interest as lender. If developments in this company
motivate selling shares, and if this in turn could put at risk the capital the bank has lent to the
company, there is a risk that the bank would try to influence the investment fund company to retain its
shares. On the other hand, this risk should not be exaggerated. In Sweden the protagonists
themselves, as well as Finansinspektionen (the Swedish financial advisory authority), have prevented
the potential conflict from burgeoning. In addition, there is considerable incentive to act in a way that
benefits savers. Bad deals would lead to a risk of savers selling their shares and perhaps most of all to
a reduction in new savings.
Dividend ban circumvented
The conflicts of interest we have seen in the mutual life insurance companies are different from those
that could arise in the bank-owned investment fund companies. This is because of the special
construction of the life insurance companies. The surplus in the mutual insurance companies shall fall
to the savers and thus may not be paid out as dividends. Despite this ban on paying out dividends, it is
common for mutual life insurance companies to be tied to property and liability insurance companies.
One may wonder why. Probably because there are other ways of earning money on savers in life
insurance. It is usually the property and liability insurance company that manages the capital of the life
insurance company and it certainly does not do this for free. Although Finansinspektionen has the task
of examining whether the remuneration paid in these cases is reasonable, there is no regular
procurement procedure for the management task and it is difficult to determine whether or not the
contract benefits savers. As it is not possible to move their money, savers have no opportunity to take
action if they are dissatisfied. The present discussions about Skandia have concerned whether it was
right or wrong to sell the management contract to Den norske bank. However, the problem in this case
is rather the fundamental contract that gave the property and liability insurance company the task of
managing the life insurance company's capital.
It is also common that property and liability insurance companies handle the sales of the life insurance
company's insurance policies. This contract was not exposed to competition, either, which means that
it is possible that the remuneration to the property and liability insurance company could be lower.
There are a number of other examples of how money could have been transferred from the life
insurance company to the property and liability insurance company. For instance, one could ask
whether Skandia AB's sale of property to Skandia Liv was really made at market prices. Folksam Liv
granted loans to its sister property and liability insurance company that had the nature of risk capital.
However, the interest on the loans appears to be lower than should be required for risk capital.
The question is how this has been able to happen for so many years, without anyone reacting. We
cannot blame it on ignorance of the problems. They have been brought up in various contexts over the
years without this triggering any major discussion. Perhaps the current system has become so firmly
established in our minds that we have been unable to see the actual risks. This has been the case for
me. During the late 1980s I was on the board of directors of Försäkringsinspektionen (the Swedish
private insurance supervisory service), but I cannot remember this issue being discussed, despite the
fact that the problems were the same then as now. Everyone, from the government and
Finansinspektionen to corporate management and consumer organisations, was aware of the
problems. Despite this, very little has been done, apart from the introduction of the possibility to
establish profit-making companies.
Lock-in effects
I have tried to give examples of conflicts in the savings chain that could have a negative effect on the
value of savings. Such conflicts are inherent in all forms of financial delegation and are not, of course,
limited to Sweden. The prevailing institutional structures in individual countries can lead to conflicts
being expressed in different ways. But the fact that competition for savers' money is not allowed to
take full effect is probably an important factor in most cases.
From an international perspective, it is difficult to claim that the supply of savings products in Sweden
is too small. On the contrary, Sweden fares well in this type of comparison. Here the problem is rather
that competition is curbed by various types of deadlock effects that stem from the old days of
regulation in Sweden.
The capital flow to the AP pension funds is safeguarded by legislation. Regardless of what we think of
their management, there is little we can do to influence it. Formerly, the AP funds were used for
political aims to subsidise house building by allowing them to buy housing bonds and treasury bonds
below market rates. Fortunately, this is not the case today. Other parts of our pension savings have
gone via collective agreements in the labour market to companies such as Alecta and AMF. We
cannot influence the management of the money there either. Some life insurance and pension policies
are in turn protected by taxation regulations. The premiums in the "P insurance policies" were made
tax deductible in income tax returns, which together with the limited opportunity for transferring money
meant that savings were locked in.
There is also a lock-in effect with regard to savings in the investment fund companies attached to the
banks. Reluctance to pay capital gains tax when selling mutual fund shares can make savers less
willing to sell their shares, despite dissatisfaction with the fund growth. This is of course a problem that
also affects those saving directly in equity. These various forms of lock-in effects have curbed
competition in the savings market, which together with the obscure ownership in many limited
companies, has probably been to the detriment of savers.
A further problem that is of significance to competition concerns financial advice. In the United States
there is a whole cadre of independent financial advisers who have no connection to the companies
selling various savings products. This is not the case in Sweden. Here we still accept that our
investment advice comes from the same people who then earn money on managing our savings. It is
self-evident that such a close linking of these roles is far from ideal.
Time for change
So what shall we do? We must ensure that confidence can be maintained in the market participants.
There is evidently a need to review the institutional framework regarding the mutual life insurance
companies. It is not sufficient to have a general requirement for them to reorganise themselves. The
government's decision to appoint a commission to look into these problems is therefore a welcome
one. Until this commission puts forward its proposals, it is important to ensure that people who abuse
their positions should be replaced. This is precisely what has happened at Skandia. That is good. I
think it illustrates that the market economy works. Even if people are upset over events in the life
insurance companies, this should not need to entail widespread confidence crises. Some form of
prevention can be achieved by pointing out the alternatives for efficiently-functioning, diversified
savings offered in the market. Broad index funds with low fees are one example.
It is also important to point out the need for serious financial advice independent of companies selling
savings products. There should be a market for this in Sweden, even if it is expensive.
However, releasing the entire potential competition in the savings market is not what would provide the
best guarantee that savers' capital will not be used for other purposes than improving savers' finances.
If we are to achieve this, the lock-in effects currently hampering competition must be broken. This in
turn requires changes in tax regulations and better opportunities for insurance policyholders to move
their money. I am aware that these are complicated issues. However, this does not make it any less
important to deal with them as quickly as possible.
Thank you.