Rating culture is crucial for responsible investing

FRC 2“Embedding a healthy corporate culture, through improving behaviour, is vital to the success of any business ….. we want to see behaviour improve through a healthy corporate culture. This is high on the FRC’s agenda ……. Ultimately it is for boards, preparers, auditors and other professionals to implement the standards we set; our role is to support them as far as possible by reinforcing best practice…”

Sir Winfried Bischoff, Chairman, Financial Reporting Council, Financial Times Banking Standards Conference, 08 March 2016.

The investment world is grappling with how to analyse corporate culture and its impact on organizational value. This is true across all industry sectors but more acute within banking than in any other. The reason culture or, perhaps more critically, governance is so high on the FRC’s agenda is that it is the bedrock of sound, long term value and investment. Since the latter part of the 20th Century good governance has had to vie with short-termism and the advent of shareholder primacy.  The FRC is acknowledging that it has to regain much of the ground that has been lost: it is not the only organization with this aim.

The UN PRI (Principles for Responsible Investment) recently announced that –

“Investors across our signatory network are being asked to support a call for credit rating agencies to incorporate ESG into their credit analysis in a more systematic and transparent way.”

At its ‘Culture and Conduct in Banks’ webinar on 27 April, Paul Cox (Investment Adviser, National Employment Savings Trust) remarked that probably the most important question that investors need to ask is the simplest – what is the purpose of banks? Are they there to serve shareholders or society? We wholeheartedly support Cox’s position. ‘Good’ governance can only be judged in relation to the declared purpose of any organisation but if the organization is not ultimately focused on serving society then the term governance soon loses all meaning.

Recognising that this is the core problem behind the present malaise is a good start but what can be done about it?  Where are the analysts who have been professionally trained and accredited to undertake this broader perspective?

At MI, we have spent the first 3 years of our work refining our human governance framework and are now working with a wide variety of stakeholders to provide the expertise and quality oversight for such work (see our ‘Human Governance Steering Group‘)

This is a new and emerging field of enquiry and we are encouraged to see that some firms are already attempting to make the critical link between “culture” and value. In a very recent ‘ESG Case Study’ entitled – ‘Barclays: banking on cultural change’ – written by Hermes’ Head of Responsibility and a Senior Credit Analyst – the authors conclude:

“Barclays has made substantial changes in all of the areas we targeted, particularly its culture….”

Hermes is recognised as a well-trusted investment house and, of course, has developed significant expertise in credit analysis; but it has only just begun to try and incorporate an ESG or, more specifically, human governance perspective. It appears Hermes’ analysis relies heavily on Barclays own interpretation of what ‘cultural improvement’ means and it is understandable that it would take Barclays statements at face value in the absence of any objective benchmark or standard. However, MI teaches its own analysts to validate any company statements with convincing evidence not only that the company’s culture has actually changed but also how this is impacting on value (in this particular case creditworthiness). The mere existence of so-called transformational initiatives (e.g. Barclays “Citizenship”) does not, in isolation, provide credible evidence of changes in attitudes, behaviour or impact.

Conversely, OMS LLP (and MI accredited) recently issued a Barclays research note that advises:

“The behaviour and practices that have resulted in so many fines is also worrying because it reveals Barclay’s willingness to ignore its own stated principles and standards, post GFC. There is little evidence that Barclays recognises the systemic nature of this cultural risk and there is no sign of a whole system approach to dealing with the problems that have arisen.”

The OMS note provides a rich seam of evidence to support its view: from Chair and CEO public pronouncements, to analysis of company-provided evidence and externally measured value outcomes such as operating margin and customer service.

More importantly OMS’s OMI (organizational maturity rating index) is predicated on the founding principles of MI – the Ten Pillars – that connect human capital to value and risk, and follows the same rating scale as a typical ‘AAA’ scheme. From this perspective Barclays achieved a recent rating of B- which can be compared not only with all other banks but companies from all other sectors.  The OMI is a universal rating system in the same way as credit rating. In this context, the ‘OMR Analysis & Research Note’, which covers the research that led to the OMR rating, reaches very different conclusions about Barclays. This methodology is now the basis for our Human Governance research programme with Harvard Law School.

Issues of human governance are problematic. The connections between how people are managed in organizations and how those organizations, as whole systems, perform are never linear or straightforward.  The world of investment analysis has realised that human capital matters but it requires a much more multi-faceted approach, together with a sophisticated set of analytical tools, to provide the right perspective and insights.

MI strongly supports efforts like Hermes and OMS LLP to link culture to value. However, we are the first to admit that this emerging field of ‘human governance value analysis’ is in its infancy and it needs to become professional if we are all to witness significant and lasting  progress towards banks getting back to their core, societal purpose whilst still maximising long-term investor value.  Indeed, while we cannot expect the FRC to already have the necessary skills in this new field it cannot do its job of standard setting, best practice and regulation without it.

If, as an individual, you would like to develop as a Human Governance Value Analyst, or you are interested in helping your own organization to develop its capability in this new discipline, then please contact Paul Kearns. If you are interested in joining our newly-formed Human Governance Steering Group then please contact Stuart Woollard.

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