Interview: John Kay, former director of Oxford’s Said Business School

‘The first step in cleaning up is to admit you’ve made a bit of a mess’

WHERE have all the big British companies gone? wonders Professor John Kay. The former director of Oxford’s Said Business School recalls the day when chemicals firm ICI and engineering giant GEC weren’t just the biggest companies in the UK – but also in the world.

Such superiority is no longer the case. Two of the biggest firms in these sectors now are BASF and Siemens – both German. In the US, it is Dow and GE.

Sign up to our daily newsletter

The i newsletter cut through the noise

There is a problem, believes Kay, and the Scots-born economist has been devising a theory as to why this is – and how to solve it.

In July, Business Secretary Vince Cable tasked him with leading a review of the problems with British companies. Taking in equity markets and long-term decision making, Kay published an interim report last month which set out the scope of the review. Sprawling over 56 pages, the interim findings set out the complicated task that faces him – and part of that difficulty is defining the problem.

“Markets are for customers, not for market participants,” muses Kay. “That sounds obvious but that is not the way the world has been. What we have seen in the past 20 or 30 years – as the financial sector has expanded – is the ‘financialisation’ of companies, which has got in the way.

“The bottom line is, what we need is a financial system that is an order of magnitude simpler than the one we have.”

Fifty years ago, shares were almost all owned by individuals and managed by their stockbrokers. But in the 1980s and 1990s, financial markets changed dramatically, due in part to Margaret Thatcher’s “big bang” deregulation of financial markets. As a result, investors were overtaken by pension funds and insurance companies.

“But even their share ownership has diminished – about 20 per cent, having been over 40,” observes Kay. “The people who matter now are asset managers.”

Following the big bang, there was an explosion in the financial services sector and jobs – but the problem was the system was built before there were trusted advisers. During this time, Kay notes, the number of listed firms that were supposed to benefit from investment has fallen by half, and the end investors in those firms – savers and pension fund beneficiaries – have had a “terrible decade”. But, at the same time, a resulting host of what Kay called “market participants” have had a rather better decade.

According to Kay, after deregulation the system had to have a number of guards built into it.

“But who guards the guards?” Kay quipped to an audience of business leaders in Edinburgh last week.

“And if you need guards to guard the guards, then you also need guards who guard the guards who guard the guards.

“There is too much intermediation – the list goes on forever. Corporate advisers, registrars, nominees, asset managers, fund of fund managers, investment consultants, wrappers, platforms, IFAs, distributors, compliance officers, performance measurers, rating agencies.

“And you need lawyers and accountants for all of these as well. It is not surprising if this total runs off with all the cake.”

Not only does a host of advisers suck capital from the chain, but it causes a “misalignment” of performance incentives.

He admits that the scope of his review is to look at all sorts of “incentives”, which most people recognise as “fat cat” pay.

But Kay says that he’s had to “tread gingerly” – not only has this been the subject of several reviews already, but he argues that, if he had tackled the subject directly in his interim report, no-one would have read what else was in it. There will be more on this in his final report when it comes out in July.

But incentives and pay are a problem, according to Kay. The trouble is that the asset managers – the ones who control most of the shares – are incentivised with relative performance, not out-performance. As a result, this does not improve the value of companies.

According to Kay, markets don’t actually act as a source of capital for businesses. Rather they influence management – share prices go down if investors don’t like what managers of the business are doing.

Markets also provide “liquidity events”, such as when they float on the stock market but, more recently, investors have been asked to cough up capital for banks on the verge of failure.

In his initial report, Kay outlined the scope of the problem, but can even his lucid description of the complexities of the financial problem solve it? “No, but that is where we are at the moment. We are only half way through this. Stage one was to get people to tell us what was happening. Stage two is to pull it all together and try to make sense of it. Stage three is to say what we might do about it.”

Kay was among the first economists to join First Minister Alex Salmond’s committee of economic advisers (CEA).

He spent the duration of the 2007-11 parliament when the SNP was in a minority on the CEA, but left when the SNP won a majority last year, after publishing a salvo in Scotland on Sunday – The Scotsman’s sister newspaper – explaining why he thought further devolution with economic powers was a better solution for Scotland than independence.

He clearly does not fear upsetting people. But can he change the fabric of the function of the economy?

“In a sense the industry is responding positively. So far the thrust of what they have said to us, is that the system isn’t working very well but it is not our fault. And in a sense it isn’t. The problems are systemic, not due to bad people.

“We made mistakes as we plainly did in the deregulation and expansion of financial services in the 1980s.

“Let us recognise our mistakes and start remedying some of them.

“That comes to the demand for simpler finance, to focus on a financial sector that achieves the needs of the real economy.”

Will he, or any of us, see it in our lifetime?

“Perhaps if it happens it is because I am a pessimist,” he says.

“My big fear is that we have in the next decade a much larger financial crisis than we have yet experienced – if we don’t do exactly what I say.”