Common Contribution of Caisse des Dépôts and Cassa Depositi e Prestiti to the consultation on Financial Supervision

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1 Common Contribution of Caisse des Dépôts and Cassa Depositi e Prestiti to the consultation on Financial Supervision Long-term investors, prudential framework and market stability. Caisse des Dépôts, Cassa Depositi e Prestiti chose to answer the DG Internal Market consultation on financial supervision as they are convinced that long-term investors can play an essential role in : - financing specific long term purposes, thus contributing to economic growth ; - ensuring stable support to companies capital, hence promoting their investment strategies; - stabilizing markets; provided that the regulatory framework in which they operate is adapted to their mission and specificities. 1. Diagnosis: Short-termist behaviours are at the heart of the crisis causes In its diagnosis of the financial crisis, the de Larosière group pinpoints the effects of short-termist behaviors, which have been amplified by certain corporate governance, accounting rules and remuneration practices (cf. para 111 Group de Larosière Report). Contrary to short-term investors, such as traders, Long-Term Investors (LTIs) can be defined as financial institutions that invest in markets on which they anticipate long-term trends can offset short-term price volatility. They send a signal of confidence in the long-term structural profitability of markets and can offset negative effects of short-termist behaviors, as : they are prepared to accept risks that short-term investors are unwilling to take. They are, for example, in a position to finance infrastructures, the profitability of which can only be measured over a very long period, but which is essential for sustainable growth; they can adopt a counter-cyclical approach, as they can smooth their gains and losses over time and publish high quality long-term oriented information (cf. Annex 1); Potentially, the definition of a long-term investor goes far beyond that of a sovereign wealth fund, as it could encompass pension funds, some insurance pools and even some hedge funds. Therefore, in markets characterized by unprecedented volatility, the presence of long-term investors is more than ever essential. As their role is totally different from short-term investors one, a specific set of rules should be designed for LTIs. Recommendation: - Values of long term investment should be promoted by the representatives of the EU in the framework of the G20 discussions on the elaboration of a Sustainable economy Charter and the definition of key principles (cf para 21 of the London Summit Declaration) - A specific set of rules regulating long term investment should be defined; - this regulatory framework should be designed as to enhance stabilizing effects of long-term investment through adapted prudential rules and accounting norms ; and - promote long term investors specific investment strategies. 1

2 2. Recommendations on the content of a specific LTIs set of rules a. Long-term investors must be regulated either under existing regulation frameworks or under an ad hoc one. While clearly recognizing long-term investment as beneficial, neither the de Larosière report, nor the Commission s communication clarifies the framework within which LTIs should operate. These clarifications must be targeted on two issues: the relationship with the principal and preventing systemic risk. Relationship with the principal: The relationship with the principal, shareholder or public authority, must be focused above all on preserving the long-term character of the investor and particularly the permanence and stability of his equity capital; In the case of a private sector principal, the relationship will be reflected in the accounting and prudential framework, which must specify the investor s will to consider his investment as long term in nature; If the principal is in the public sector, the State, as a shareholder, must undertake to guarantee the credibility of the investment through a legal framework, which clearly describes the medium-term contractual relationships. Preventing systemic risk: Given their size and their structural bias as long-term investors - which, if it were to be suddenly reversed, could lead to a collapse of the financial system LTIs can potentially generate systemic risks. Moreover, if an institution chooses to ring-fence its short-term investments on the one hand and its long-term investments on the other, each pool of assets must be in a position to meet its liabilities and the conditions in which assets may be transferred from one pool to the other properly supervised. This regulatory framework could take three different forms : - a sub-category of banking regulation (e.g. in the case of public financial institutions) - a sub-category of insurance regulation (e.g. in the case of insurance pools for example) - an ad hoc category. Although the use of existing set of rules (Basel II and Solvency II) would ensure a swift implementation, it might not totally fit LTIs specificities. A contrario, a specific set of rules could only be envisaged in the mid run, but could encompass both LTIs active in the banking and insurance sectors and better fit specific requirements, such as the relationship to the principal. b. Constraints must be imposed on the long-term investors to promote their stabilizing effect i. Capital requirements and contra-cyclical effects The investor must be able to prove that he is able to avoid a distress sale of his holdings and therefore to keep them for the duration of the minimum holding period used in the calculation of long-term economic value. In addition, the contractual relationship between the principal (shareholder or public authority) and the fund manager must clearly document the balance to be struck between short-term concerns (particularly dividend payments) and long-term concerns (replenishment of shareholders funds) in a manner consistent with the time horizon ascribed to the investments. Finally, the minimum holding period must be respected, so as to avoid the institution arbitraging between the long-term economic value and the market price at any given time. Therefore, two options could be envisaged 2

3 Option 1: LTIs fall under existing banking or insurance regulation. In that case, recommendation 1 and recommendation 5 of the de Larosière group should be amended as follows: Recommendation 1: The Group sees the need for a fundamental review of the Basel 2 rules. The Basel Committee of Banking Supervisors should therefore be invited to urgently amend the rules with a view to: - gradually increase minimum capital requirements; - reduce pro-cyclicality, by e.g. encouraging dynamic provisioning or capital buffers; and encouraging long-term investors to keep their holdings for the duration of the minimum holding period used in the calculation of long-term economic value. - introduce stricter rules for off-balance sheet items; - tighten norms on liquidity management; LTIs should respect the tightest levels of liquidity ;anagement norms, and - strengthen the rules for bank s internal control and risk management, notably by reinforcing the "fit and proper" criteria for management and board members. Furthermore, it is essential that rules are complemented by more reliance on judgment. Recommendation 5: The Group considers that the Solvency 2 directive must be adopted and include a balanced group support regime, coupled with sufficient safeguards for host Member States, a binding mediation process between supervisors, specific requirements as regards holdings and relation to principal for Long-term pool of insurance investors and the setting-up of harmonised insurance guarantee schemes. Option 2 : LTIs fall under an ad hoc regulation. In that case, a specific recommendation should be added after recommendation 1 of the de Larosière group, as follows: Recommendation 1bis: The European Commission should urgently come up with a specific set of rules regarding long-term investors with a view to: - framing the contractual relationship between the principal (shareholder or public authority) and the fund manager must clearly document the balance to be struck between short-term concerns and longterm concerns in a manner consistent with the time horizon ascribed to the investments. - encouraging long-term investors to keep their holdings for the duration of the minimum holding period used in the calculation of long-term economic value. This constraint must be applied to the entire maturity profile of the investor s liabilities, which has to be matched with that of its assets, the liquidity gap being the best method to assess the match. - requiring LTIs to respect excellent liquidity quality norms. ii. Accounting and regulatory impact of LTIs status LTIS assets, and particularly equity portfolio, should be considered, for accounting and regulatory purposes, at their (long-term) economic value rather than at their (short-term) market value. Market value cannot be completely ignored and remains a valuable yardstick, but only as a last resort. Long-term economic value is central to any valuation method: it may be based, for instance, on an assessment of the future cash flows from the security, as long as these can be considered as sustainable over a long period. Long-term economic value is based on an explicit minimum holding period. 3

4 Recommendation 4 of the de Larosière report should therefore be amended as follows: Recommendation 4: With respect to accounting rules the Group considers that a wider reflection on the mark-to-market principle is needed and in particular recommends that: - expeditious solutions should be found to the remaining accounting issues concerning complex products; - accounting standards should not bias business models, promote pro-cyclical behavior or discourage long-term investment; in particular long-term investors assets, and particularly equity portfolio, should be considered, for accounting and regulatory purposes, at their (long-term) economic value rather than at their (short-term) market value. - the IASB and other accounting standard setters should clarify and agree on a common, transparent methodology for the valuation of assets in illiquid markets where mark-to-market cannot be applied; - the IASB further opens its standard-setting process to the regulatory, supervisory and business communities; - the oversight and governance structure of the IASB be strengthened. 4

5 Annex 1: Long-term investors and market volatility By S. Moinas, Toulouse School of Economics Long-term investors may have a direct impact on the financial market via two channels. First, if long-term investors are characterized by a higher risk tolerance, they may require a lower risk premium. Under a reasonable restriction on investors preferences (convex absolute risk tolerance), investors with a longer time horizon are indeed characterized by a higher risk tolerance (for a survey, see Gollier, 2001). But the risk premium required by investors can typically be broken down into two main components: i) the level of risk, often measured by asset volatility, and ii) the unit price of risk, which mainly relies on risk aversion. If long-term investors tolerate a higher level of risk thanks to a lower risk aversion coefficient, then they should require a lower risk premium. Thus, they would be ready to buy assets at a higher price (that is, they would require a lower return for the same asset). Such behavior may for instance cushion a fall in asset prices during a crisis, and therefore, lower asset volatility. Second, long-term investors may have the opportunity to smooth revenues in the long run. As a consequence, they may incur losses that could be offset by revenues in the future. Glosten (1989) analyzes the role of the Specialist in the New York Stock Exchange. In particular, he questions his monopoly power. He does indeed have the opportunity to bypass time and price priority rules in the limit order book. Glosten, shows that, counter-intuitively, this break on competition improves market liquidity. Thanks to his monopoly power, the Specialist may lose profits on the initial trades, but since trades reveal information, he would assimilate this information, which would make subsequent trades profitable. This would offset initial losses. Similarly, the long-term investor has the capacity to incur losses in the short term, if he can recover revenues in the long run. Naturally, this depends on the nature of his objectives, and on the way he is regulated. However, in the absence of market imperfections, the impact of the long-term investor would be limited. First, long-term investors, like insurance companies, only aggregate investment demand from small (typically, retail) investors. The same argument on higher risk tolerance could apply to small longterm investors, in the absence of institutions having a long-term investment horizon. Second, the key to Glosten s (1989) argument is the Specialist s supposed ability to recover initial losses, thanks to monopolistic rents. In the paper, these rents are based on informed trading. For the long-term investor however, and in the absence of market imperfections, nothing guarantees that he would be able to recover losses in the future. As a consequence, it seems hard to justify the profitability of counter-cyclical investments. Let us assume for instance that the long-term investor is able to extract information from his initial investments. In this case, any piece of information that could be valuable for traders (institutions) would be acquired. In the absence of constraints, this information would be traded on and incorporated into prices [market efficiency]. Competing institutions are likely to pre-empt the longterm investor in informed trading. However, in the presence of market imperfections, due to regulation, delegation or psychological biases, the impact of long-term investors may be more important. In particular, we will focus on three main sources of imperfection: - Investors potential psychological biases. - Regulation and other factors (e.g. financial crisis, illiquidity ) which may impose portfolio constraints (Basel II). 5

6 - Regulation and various other factors (cost heterogeneity, herding, rate of information arrival ) which may induce short-termism. Market volatility can be broken down into two main components: i) good volatility, i.e price variations which are due to the incorporation of new information on the assets fundamental value, and ii) bad volatility, i.e price variations which are only due to noise trading. The common feature of both these imperfections is that they can increase the fraction of market volatility due to noise trading. The intervention of a long-term investor can therefore be useful in lowering noise trading volatility. 1. Retail investors may suffer from a behavioral bias of myopic loss aversion. The principle of myopic loss aversion is based on the assumption that losses feel worse than gains of an equal amount. Risky investment choices that show average high returns are usually characterized by occasional short-term losses, which will be more than matched by gains in the long run. An overestimation of losses compared to gains can render such an investment less attractive, compared to a safer investment choice with lower average returns but less volatility. Myopic loss aversion is thus crucial for long-term investment decision-making. Myopic loss aversion has been observed repeatedly in experimental studies (Gneezy and Potters (1997), Thaler et al. (1997). Hopfensitz and Wranik, 2008 show that investors who encounter early losses during the experiment will show stronger myopic loss aversion afterwards than investors exposed to lower initial losses. Furthermore, the decrease in investment activity for unlucky participants is even stronger when the reporting frequency of gains and losses is high. Therefore, if investors (either retail or fund managers) withdraw their savings from risky capital markets after incurring losses, such behavior can lead to a further decrease in the level of prices by the law of supply and demand, even though this decrease would be, to some extent, unrelated to the assets fundamental value. Long-term investors can therefore, thanks to their ability to invest counter-cyclically, profitably invest in risky assets because they can recover losses in the long run without any monopoly power, once prices revert to fundamental value. 6

7 2. Financial institutions face portfolio constraints. Calvo (1999) argues that Wall Street was the carrier of the Russian virus in the fall of 1998 when binding margin constraints forced leveraged investors (most notably LTCM) to curtail their exposure to all emerging markets. Kaminsky and Reinhart, (2000) document that Thailand's 1997 currency crisis led to capital losses for Japanese banks, forcing them to curb their lending to other Asian countries. This newer literature highlights the prominent role that financial friction, in particular institutional or government-imposed portfolio constraints, plays in the propagation of turmoil via financial centers. Pavlova and Rigobon (2008) introduce portfolio constraints in a three-good three-country dynamic equilibrium model, in order to analyze the phenomenon known as contagion. They show that such portfolio constraints may give rise to important flight to quality effects such as amplification. As a consequence, portfolio constraints are shown to exacerbate market volatility. Here again, the counter-cyclical behavior of a long-term investor who does not face such portfolio constraints could reduce market volatility. It is also worth noting that such an intervention has a leverage impact. 3. Long Term Investors have bigger incentives to acquire long-term information The Market Efficiency Hypothesis is one of the basic rules of finance. And yet, prices may not incorporate long-term information. The literature proposes different explanations of this phenomenon. A first series of papers shows that it may be too risky to trade on long-term information, when i) it is uncertain whether future prices will reveal this information (Dow and Gorton, 1994), ii) arbitrage in the long-run is more costly than in the short-run (Shleifer and Vishny, 1990), or iii) prices are volatile (Holden and Subrahmanyam, 1996). Casamatta and Pouget, 2008 propose an alternative explanation: delegation contracts between fund managers and investors induce short-termism. In their model, actively managing a portfolio is costly and subject to moral hazard. On the one hand, the manager has to make an effort to gather relevant information on the long-term fundamental value. But on the other hand, it is difficult for the investor to know whether a manager is actively searching for information or not. As a consequence, the optimum contract would be one in which investors compensate the fund manager both in the short-term and in the long-term, in order to provide him with the right incentives to acquire information. But if they are (at least partially) compensated for their short-term performance (as in Guembel, 2005), fund managers may have incentives to acquire more short-term information, and less long-term information. Moral hazard therefore induces short-termism. And short-termism increases asset volatility. A long-term investor not subject to delegation would not be tempted by short-termism and would therefore benefit from long-term information acquisition. To sum up, in all the situations described above, the consequences of market imperfections are an increase in the noise trading component of market volatility. References Calvo, 1999, Contagion in Emerging Markets: When Wall Street is a Carrier," working paper, University of Maryland Casamatta and Pouget, 2008, Fund managers contracts and short-termism, mimeo, Toulouse School of Economics. Dow, James, and Gary Gorton, 1994, Arbitrage Chains, Journal of Finance, 49, 3, Gneezy and Potters, 1997, An experiment on risk taking and evaluation periods. The Quarterly Journal of Economics, 112(2): Glosten, Lawrence, 1989, Insider Trading, Liquidity, and the Role of the Monopolist Specialist, Journal of Business, 62, 2, Gollier, 2001 Guembel, Alexander, 2005, 'Herding in delegated portfolio management: When is comparative performance information desirable?', European Economic Review, Vol 49:3, 2005, pp

8 Holden and Subrahmanyam, 1996, Risk aversion, liquidity, and endogenous short horizons, Review of Financial Studies, Vol. 9 Issue 2, p691. Hopfensitz, Astrid, and Tanja Wranik, 2008, Psychological and Environmental Determinants of Myopic Loss Aversion, mimeo, Toulouse School of Economics. Kaminsky, G. L., and C. M. Reinhart, 2000, On Crises, Contagion, and Confusion, Journal of International Economics, 51(1), Pavlova, Anna, and Roberto Rigobon, 2008, The Role of Portfolio Constraints in the International Propagation of Shocks, Review of Economic Studies, Vol. 75 Issue 4, p Shleifer and Vishny, 1990, Equilibrium short horizons of investors and firms, American Economic Review, Vol. 80 Issue 2, p148 Thaler, R., Tversky, A., Kahneman, D., and A. Schwartz, 1997, The effect of myopia and loss aversion on risk taking: An experimental test. The Quarterly Journal of Economics, 112(2):