Representation of public interest in banking #5 - Shareholder Value in Banking: Legal Fictions and Financial Stability
This article is part of a series of blogs on a Finance Watch project on the representation of public interest in banking. Read more on the project here.
Despite the recent infusions of large amounts of public money into large financial institutions and the ongoing implicit state guarantees provided to the global financial system, the public interest continues to lack formal representation in banking. Moreover, the debate on corporate social responsibility remains dominated by the shareholder value paradigm. The following post discusses the origin of this paradigm and the legal position in most jurisdictions in relation to the pursuit of shareholder value. It also analyses the specific dangers adherence to shareholder value poses in the case of banks, before canvassing possible remedies.
The idea that the corporation exists to serve the exclusive interest of its shareholders remains the dominant framework in economics and finance (Shleifer and Vishny 1997). This view may be traced to Milton Friedman’s seminal article, in which he argued that the “there is one and only one social responsibility of business – to use its resources and engage in activities designed to increase its profits” (Friedman 1970). Many studies into corporate governance theory and practice were conducted in the wake of this statement. The most famous of these, by Jensen and Meckling (1976), purports to provide empirical support for the benefits of limiting agency costs – that is, the costs imposed by managers on the ‘owners’ of firms they are entrusted to serve. This argument provided sustenance to another of Friedman’s conclusions; namely, that the “whole justification for permitting the corporate executive to be selected by the stockholders is that the executive is an agent serving the interests of his principal.”
Cartoon from The New Yorker
Yet, these ideas – at least from a corporate law perspective – are deeply flawed, and the notion that shareholder wealth maximisation should be pursued to the exclusion of other interests remains arguably the most misleading mantra in corporate governance and finance. Generally, at law in most jurisdictions a corporate executive is not appointed, as Friedman claims, to “serve the interests of his principal” – she is appointed to serve the interests of the corporation, which constitutes a distinct entity with separate legal personality and its own interests (Johnston 2011). Accordingly, except in exceptional circumstances, boards of directors must discharge their duties to the corporation, not to shareholders (Stout 2012). Moreover, shareholders do not legally “own” corporations; they own property rights in the form of shares, which are intangible, tradable contractual rights granting certain limited benefits to their holders (Kay and Silbertson 1995). From the point of the law, therefore, shareholder value is not necessarily the appropriate paradigm through which to approach issues of corporate governance and strategy.
In the case of banks, maximising shareholder value may be even more misguided. First, unlike in the case of most other forms of corporation, there are explicit outside financial interests at stake in relation to the management and conduct of large banks. Banks perform critical utility functions in modern economies: they provide clearing and payment systems; act as stores of value; provide market liquidity; and are conduits for monetary policy transmission. Any disruption to their operations may therefore have far-reaching effects. Yet, their actions may impose costs on third parties which they cannot internalise and losses may quickly spillover into other areas of the economy. Because of this, banks are afforded very generous state-backed deposit-insurance schemes and lender of last resort facilities. They are also granted unique legal licenses to create liabilities (bank deposits) at will, which are exchangeable at par for state money. These advantages are reflected in the lower relative borrowing costs and higher credit ratings enjoyed by large financial institutions, which help shield them from competition and confer direct financial benefits on bank shareholders (Avgouleas and Cullen 2014). Whilst additional standards of regulation and conduct are imposed upon banks and their directors, these obligations are often limited and difficult to enforce.
"This prediction was evidenced during the financial crisis, when banks with more shareholder-centric boards suffered the greatest losses"
Evidence gathered since the financial crisis points to convincing reasons to be wary of pursuing the interests of shareholders exclusively in banks. Bank risk-taking is positively associated with comparative shareholder power (Laeven and Levine 2009). This prediction was evidenced during the financial crisis, when banks with more shareholder-centric boards suffered the greatest losses (Beltratti and Stulz 2012). Indeed, higher institutional investor equity stakes in banks also increases risk-taking (Barry et al 2011). In fact, the financial crisis revealed that those banks in which bank executives’ interests were most aligned with those of their shareholders performed worst over that period (Fahlenbrach and Stulz 2011). This is perhaps not surprising. Shareholders in the financial sector – which is characterised more than other sectors by fads, swings in confidence and pronounced volatility – are much more likely to be short-term, holding their shares for on average, only seven months (Haldane 2010). Bank shareholders therefore have strong motives to incentivise managers to assume higher leverage in the interests of short-term expansion (Admati et al. 2016) which is evidenced by the widespread use of compensation targets based on return-on-equity, which is amplified by increased use of debt (Cullen 2014; Avgouleas and Cullen 2015).
Cartoon by Bill Proud
Despite this vast empirical evidence, shareholder value maximisation remains the favoured paradigm in most financial markets. There are legal mechanisms which could be adopted to ameliorate the risks posed by shareholder power. The first might be for direct representation of the public on the boards of any banks which benefit from state-backed guarantees, or at least the imposition of duties on directors to consider the public interest. A version of this was enshrined in Irish law in the Credit Institutions (Stabilisation) Act 2010 under which ‘public interest directors’ were appointed to the boards of Irish credit institutions which benefited from state assistance. Although these appointment powers expired at the end of 2014, all directors of Irish banks remain obliged to have regard to a wide range of public interest factors in the performance of their functions, which override their duties to the company in the event of conflict (Clarke and Henderson 2016).
In the U.S. context, prominent academic Schwarcz (2016) has called for amendments to corporate law to introduce a “public governance duty” at financial firms not to engage in excessive risk-taking that could systemically harm the public. A more far-reaching alternative is provided by Kane (2016), who argues for the explicit legal recognition of taxpayer interests (based on the implicit rescue costs every large bank enjoys) in any financial institution which poses systemic risk and would be likely require rescuing in the event of failure. Some jurisdictions have legislated to increase managerial accountability to the public for losses their bank suffers. In the U.K., for example, the Financial Services (Banking Reform) Act 2013 established a new Senior Managers Regime which, amongst other things, introduces civil and criminal penalties for individuals found guilty of recklessly taking actions or failing to prevent actions being taken in areas for which they had responsibility, which result in their bank requiring taxpayer assistance or cause it to fail.
"Whether by accident or design, large systemic banks still enjoy significant benefits and guarantees not available to other corporations"
These mechanisms are certainly worth exploring, and the U.K example may prove to be a worthwhile advance (Cullen 2017). Yet, in spite of the fact banking remains a quasi-public activity, an equitable balance between who bears the costs and receives the benefits from banking activities remains elusive. Whether by accident or design, large systemic banks still enjoy significant benefits and guarantees not available to other corporations and their positions are in part entrenched by those benefits. They remain shielded from competitive market forces. Banks’ global footprints continue to expand, and the operations of some continue to pose a grave threat to the global economy. The main beneficiaries of these benefits are bank shareholders, whose interests directors are guided to prioritise. And still, their profits remain underwritten by public money, with little-to-no formal representation of the public interest.
Admati, A. R., DeMarzo, P.M., Hellwig, M.F., and Pfleiderer, P. 2016. “The Leverage Ratchet Effect.” Stanford Graduate School of Business Working Paper No. 3029.
Avgouleas, E. and Cullen, J. 2014. “Market Discipline and EU Corporate Governance Reform in the Banking Sector: Merits, Fallacies, and Cognitive Boundaries.” Journal of Law and Society, 41(1): 28-50.
Avgouleas, E. and Cullen, J. 2015. “Excessive Leverage and Bankers’ Pay: Governance and financial stability costs of a symbiotic relationship.” Columbia Journal of European Law, 21(1): 1-46.
Barry, T., Lepetit, L. and Tarazi, A. 2011. “Ownership structure and risk in publicly held and privately owned banks.” Journal of Banking and Finance 35(5): 1327-1340.
Beltratti A. and Stulz R.M. 2012. “The credit crisis around the globe: Why did some banks perform better?” Journal of Financial Economics 105(1): 1–17.
Clarke, B. and Henderson G.E. 2016. “Directors as guardians of the public interest: lessons from the Irish banking crisis” Journal of Corporate Law Studies, 16(1): 187-220.
Cullen, J. 2014. Executive Compensation in Imperfect Financial Markets (Edward Elgar).
Cullen, J. 2017. “A Culture Beyond Repair? The Nexus between Ethics and Sanctions in Finance” in Just Financial Markets: Finance in a Just Society (ed. Herzog, L. Oxford University Press).
Fahlenbrach, R. and Stulz, R.M. “Bank CEO incentives and the credit crisis” Journal of Financial Economics. 99(1): 11-26.
Friedman, M. 1970. “The Social Responsibility of Business is to Increase its Profits.” New York Times Magazine, September 13.
Haldane, A.G. 2010. ‘Patience and Finance’ Speech given at Oxford China Business Forum, Beijing, China, 2 September.
Jensen M. C., and Meckling W. H. 1976. “Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure.” Journal of Financial Economics 3: 305–60.
Johnston, A. 2011. “Facing up to social cost: the real meaning of corporate social responsibility.” Griffith Law Review 20(1): 221-244.
Kane, E. J. 2016. “A Theory of How and Why Central-Bank Culture Supports Predatory Risk-Taking at Megabanks.” Atlantic Economic Journal, 44(1): 51–71.
Kay, J. and Silbertson, A. 1995. “Corporate Governance.” National Institute Economic Review, 153(1): 84-107.
Laeven, L. and Levine, R. 2009. “Bank governance, regulation and risk taking.” Journal of Financial Economics, 93(2): 259-275
Schwarcz, S.L. 2016. “Misalignment: Corporate Risk-Taking and Public Duty.” unpublished manuscript.
Shleifer A. and Vishny, R.W. 1997. “A Survey of Corporate Governance.” Journal of Finance 52(2): 737–783
Stout, L. 2012. The Shareholder Value Myth (Berrett-Koehler Publishers).