No short answers: long-term financing

Earlier this year the European Commission published a Green Paper on long-term financing. This article is a brief précis of the European Federation of Financial Analysts Societies’ (EFFAS) responses to some of the key questions posed in the Paper.

Our responses are framed in conventional theory, where government intervention is only warranted by market failure. However, much could have been framed under newer theory, which recognises the defects of the current paradigm and embraces the views developed in the EU FINNOV: Finance, Innovation and Growth research programme (2).

The EC analysis fails to recognise adequately the competing demands for capital in an economy and conflicts between short-termism and long-termism as outlooks. We draw attention to the role of short-termism in fostering institutional corruption, a strand of research emanating from the Safra Centre for Ethics at Harvard University (3). A quotation seems appropriate: “Institutional corruption … refers to institutionally supported behaviour that, while not necessarily unlawful, erodes public trust and undermines a company’s legitimate processes, core values, and capacity to achieve espoused goals. Institutional corruption in business typically entails gaming society’s laws and regulations, tolerating conflicts of interest, and persistently violating accepted norms of fairness, among other things. …”

We draw attention to the deleterious and broad effect frequent changes in taxation, and regulation have on the willingness of individuals and companies to invest for the long-term, as documented in the recent Pensions Europe publication “Pension Funds and the crisis – national policy actions”. Much in our political system supports short-termism. Change and volatility is inherently costly and profoundly inimical to long-term investment performance.

Definition of long-term financing

The long-term concept has a number of attributes, and there is more to long-term financing than the issue of time. The floor is that long-term must mean longer than 20 years, longer than a generation. The OECD have associated long-term investment with patient, productive and engaged capital. These attributes are symptomatic of the long-term rather than causal or defining.

Many observers believe that mortgage finance is concerned with long-term investment. Undoubtedly true in the case of new construction, where it meets the OECD productive criterion, most mortgages finance the purchase of part of the existing stock and that is financing of housing consumption, not investment (4).

Housing finance introduces purpose to the use of the financing. There is a similar issue of purpose with respect to the source of the financing. Savings have many different source motivations, from the short-term to the extremely long; from saving for some specific near-term purpose, the purchase of a car or holiday, to the extremely long-term of pensions and inheritance bequests on death (5).

The term structure of savings is directly relevant to the role and ability of markets and banks to perform the maturity transformation that resolves inter-temporal imbalances between supply and demand.

Liquid assets

Liquidity is a critical issue with any maturity transformation – the ability to refinance a called deposit, or the sale of a security when necessary in the market. Financing which relies upon inter-temporal transformation is more expensive than financing which does not, as it bears the liquidity cost.

We may distinguish the short from the longterm in another way: the source of liquidity from which the contract will derive its performance. Here, the long-term is defined as reliance upon the obligor of the contract as the source of the cashflow liquidity, both during and at expiration of the contract. Reliance upon markets as sources of liquidity may be classified as short-term and speculative, not ‘patient’ investment.

The concept of ‘committed’ capital is preferable to ‘engaged’. In practice ‘engagement’ often means no more that lobbying management for higher dividends and immediate performance. Non-negotiable investments are committed capital.