"Short termism" is the problem for UK markets.

Kay review calls for end for "short termism".

Photograph: Getty Images

Short termism is an underlying problem in UK equity markets and contributes to their lack of effectiveness in supporting British business, a leading business economist believes.

In his final report for the Department of Business, Innovation and Skills on the markets and long-term decision making, Professor John Kay says that this approach is caused by a misalignment of incentives within the investment chain and the displacement of trust relationships by a culture based on transactions and trading.

He would like to see company directors, asset managers and asset holders adopt good practice statements promoting better stewardship and long-term decision making throughout the investment chain. And he suggests realigning incentives by better relating directors’ remuneration to long-term sustainable business performance and better aligning asset managers’ remuneration to the interests of their clients.

Kay also wants companies to be encouraged move away from quarterly reporting - although has stepped back from making this move mandatory - and wants to see companies disengage from the process of managing short-term earnings expectations and announcements.

“A lack of trust and poorly aligned incentives have helped create a culture of short termism in our financial markets. This is undermining their role of supporting innovative, sustainable long-term business performance," Kay says.

“We must create cultures where business and finance can work together to create high performing companies and earn returns for investors on a sustainable basis. This means moving away from a focus on short-term transactions and trading to an environment based on long-term trust relationships.

“We need to broaden the concept of stewardship through more and better cooperation between investors and companies. We don’t want more regulation; we need to ensure that the regulation of market structures and incentives work properly for the real end users.”

Kay has not found a magic bullet to deliver these outcomes, he says, but reckons his recommendations will provide “a clear vision and roadmap” leading to a financial world that behaves very differently to the prevailing one.

He has come up with 10 guiding principles and 17 recommendations designed to change the culture from short to long termist. These range from improving the incentives and quality of engagement, especially among investors in UK companies, to restoring relationships of trust and confidence in the investment chain.

Business secretary Vince Cable welcomed the report as “an insightful and powerful review which describes vividly the flaws of the UK’s financial markets” and said that he would respond in detail later in the year.

The business community has broadly welcomed the recommendations in the Kay Review, although some of the proposals around executive remuneration have raised concerns.

“The emphasis on stewardship, which should be a key objective of financial reporting, is vital for a responsible market,” said ICAEW technical director Robert Hodgkinson. “There has been a tendency for standard setters to focus on the information that investors need for buy/sell/hold decisions. ICAEW hopes that this will lead to a refocusing on what matters to firms and their investors to promote long-term performance.”

Sean O’Hare, remuneration partner at PwC, said, “It is good news that Kay is encouraging more of a long-term focus, with the long-term return to shareholders central to this. The proposal that executives should only have restricted shares with no performance conditions in the company, rather than the current complicated long-term incentive plans, is to be welcomed.

"But we need to be aware of unintended consequences, particularly Kay’s proposals that individuals hold their shares until after they leave the company. This may encourage a higher turnover of executives, or early departure if they feel the share price has peaked, so they can realise some of the value. It might be better to allow them to sell 50 per cent of any shares in the company in order to diversify their portfolio, while retaining the other 50 per cent until after they leave the company. Many remuneration committees and executive directors will welcome the simplification that Kay proposes.”

Stephen Cahill, head of Deloitte’s executive remuneration practice, said, “The Kay report contains a radical suggestion in the area of executive director pay – all shares from long term incentives should be held until after an executive’s retirement. Whilst we agree that incentives should support long term decision making, we question whether this is a simplistic solution to a complicated problem.

“Substantial executive shareholdings have an important part to play in aligning pay packages to the long term interests of shareholders. However, this proposal ignores numerous difficulties in implementation and may even have the unintended consequence of driving up executive pay further (as companies compensate executives for having to wait longer) or of encouraging executives to change jobs more often to get access to their shares.”

This article first appeared in economia.