Interview: Colin Melvin, chief executive of Hermes Equity Ownership Services

IT DID not have to happen. According to the man whose job it is to advise large public companies – in this instance, the banks – with their strategies, the global financial meltdown might have been avoided if shareholders had done more to hold banks and financial institutions to account.

Instead, a short-term focus on profits driven by a City riven with conflicts of interest means the entire global financial system has been brought to its knees and threatens to take the economy with it.

Colin Melvin wants to change this – and prevent something similar from happening again. He plans to do this through fiduciary management. As head of Hermes Equity Ownership Services (EOS), he represents the owners of $60 billion (39bn) of assets, held mainly in pension funds. EOS is part of fund manager Hermes, which oversees the BT pension fund – the largest in the UK – while the group is also one of the largest landlords in the UK. EOS manages the corporate governance of these funds alongside others, including the 3bn Lothian Pension Fund.

If softly spoken, Edinburgh-born Melvin sounds angry at times, he has a point. Since the beginning of the crisis, which was fostered by financial institutions intoxicated by cheap, manufactured debt, the value of global pension plan assets, including investments in banks and property, have plummeted by 2,680bn. Pension funds, often managed by poorly-equipped and part-time trustees, often lack the resources to make proper judgements, although companies such as EOS are changing this.

Melvin argues that large institutional shareholders must take a more active role in telling the financial institutions they own how to run the business, from how its employees are paid through to the sort of investment products they devise.

"You and I are owners of companies through the pension fund," says Melvin. "This idea that the banks which failed spectacularly recently didn't have owners is wrong. They did. The question is what were the owners doing? What were these pension funds doing as the banks wasted their money?"

Like many, the former Baillie Gifford stockbroker, who also did a stint at Standard Life, is critical of structural deficiencies in the investment industry, which result in flaws in how the financial system operates. Royal Bank of Scotland for example, which is now more than 58 per cent owned by the government, needed to be challenged more as it acquired ABN Amro and grew its wholesale banking division, he says.

"There were very few voices challenging them," says Melvin. "The City was basically cheering the company on in its push for short-term profitability.

"Of course, what has happened is that push for short-term profitability has led to a collapse of the system itself. It is difficult to overstate the seriousness of the issue. We have yet to see the real economy impact, but we will. Companies are now re-trenching and looking for cash. Banks are being managed in the same way, they are not lending to each other or customers and companies are starting to lay off staff.

"There is no demand-led reason for it; it is not a real economy effect it is a financial effect. It is the banks that have been innovative in ways that have damaged the system."

Yet he stops short of advocating a permanent ban on "spiv and speculator" short-selling.

Hermes also runs a "fund of hedge funds" that use short- selling, while its pension funds benefit from loaning its stock to short-sellers. Rather, he argues, such transactions should be more transparent, while "innovative" leverage products and derivatives – the CDOs and CDSs – should be managed with the long term in mind rather than short-term returns.

"The investment industry makes most of its money in the shadows," says Melvin. "Where things are most opaque and the least transparent, are where the most profits are made. Banks and others innovate products for short-term gain, which has been to the long-term detriment of the system itself.

"The last thing you want is an innovative bank. Good god, that is a scary thing. What we want is banks that are there to support the real economy."

The City also comes under Melvin's attack. He says the fund managers, brokers and investment banks all benefit from transactions around the stocks, while pension funds and their advisers at the "top of the tree" fail to consider the ramifications of mergers or buy-outs yet end up paying for them. What they are doing is sucking the money out of the pension funds and out of the companies, to the detriment of the pension fund companies and the enrichment of the City," he says.

"Is that too radical? That is how it works. The answer is we have to get the owners involved and acting as good stewards. It is not good enough to do a short-term dance with the assets."

Closer scrutiny of company boards by activist pension fund shareholders may be more effective than greater regulation, which should focus on rewarding good behaviour rather than trying to outlaw the bad. "We have a lot of regulation already, but not enough supervision," says Melvin.

"There is a lack of collaborative, long-term thinking and a lot of short-term competitive thinking. That needs to change. We can't solve this crisis through regulation. It is necessary, but not sufficient. But we need to look at supervision – and then regulate for good practice rather than simply prescribing bad.

"If you prescribe the bad, then it goes off somewhere else. It is like shining a light on a rodent because the instrument is very clever and can innovate."

Melvin admits a pension fund sitting down for a cozy chat with the company board – as well as ensuring its majority vote goes the right way – may not be a panacea. But more pension funds are waking up to the danger of not doing anything – or just going with the views of analysts and the City who look at quarterly returns rather than the long-term health of listed assets.

PROFILE

EDINBURGH-born Colin Melvin, 42, took over as chief executive of Hermes Equity Ownership Services in 2005. He studied history at Aberdeen University, graduating as a master of arts, before studying the subject for his doctorate at Cambridge. He joined Hermes in 2002 after holding corporate governance positions at Standard Life and Baillie Gifford in Edinburgh.

Hermes, the London-based fund owned by BT, manages 50 billion, including the BT pension fund and more than 200 funds, endowments and foundations.

Hermes Equity Ownership manages the corporate governance of pension funds.