Friday, March 12, 2010

Will the real capitalists please stand up?

It's obvious from the events of the last few years that something is wrong with our economic model. That said, it's a model has lifted millions out of poverty in recent decades, so we need to be careful when playing with it.

The left is of course claiming that the financial crisis and the recession which followed are to be blamed on the Reagan-Thatcher economic liberalism that has reigned supreme for quarter of a century.  They want more regulation, especially of the financial markets and the financial services sector.  They want a more 'social' approach to economics, with money being shared around (i.e. taken from one group of people and given to another).  They want governments to keep bailing out industry and make economic problems go away by borrowing more, taxing more and spending freely.

Those are great solutions if you like living in places like 1970s slowly-going-down-the-gurgler Britain or 2010 slowly-going-down-the-gurgler Greece.  If, on the other hand, you prefer living in a country with a bright economic future and plenty of opportunity, you will need to come up with some other ideas.  The bad news for my blog readers is that I have a few such ideas and I'm going to share them.

My basic view is that we need more and better capitalism accompanied by different forms of regulation.  I've already talked about one idea - moving the base of taxation from income to resource use.  Today I'm going to talk about another - empowering shareholders.


When you hear the word 'capitalist', what comes to mind?  Someone with a lot of money?  The manager of a Wall Street investment bank?  Donald Trump?  Those are all possible answers, but they are in fact only a small subset.

Actually most of the non-government capital investment around the world is performed by banks, pension funds, mutual funds, hedge funds and life insurers.  These organisations are all financial intermediaries, accepting deposits, contributions and premiums on a retail basis and then providing that money wholesale to consumers of capital (i.e. businesses)in the form of debt or equity.

Decisions of businesses are taken at a tactical level by management and at a strategic level by the board, whose duty is to represent the shareholders.  At the board meeting you will typically find representatives of the financial intermediaries listed above.  They appoint and sack management, set remuneration, determine risk appetite and set strategy for the business.  All well and good.

If things are so wonderful, however, why do I need to ask the following questions?
  1. How come it is common practice for bosses to get big golden parachutes even when they fail?
  2. How come top management is so grossly overpaid?
  3. How come nobody spotted the risks that hit us all in the face in late 2008?
  4. Why are most businesses run on a short-term perspective?
The answer comes from looking at the people sitting around the board table and understanding their interests. They are not the shareholders.  The real shareholders (or capitalists) are the people who entrusted small amounts of capital to their institutions - depositors, unit-holders, fund members and policyholders.  The bulk of a life insurance company's voting power on the board of another business comes not from its own shareholders, but from the assets built up by its policyholders.  Similarly the voting power of a mutual fund administrator come not from its own assets but from the contributions that other people have invested in the funds managed by the administrator.

The bottom line is that the representatives of financial intermediaries who sit on company boards are there as representatives of their companies' clients (or should be).  What happens in practice, however, is that the views of the real shareholders are largely overlooked.  Because the depositor base of a bank is so diffuse, and because the legal structure of the bank vests power in the bank's shareholders rather than its depositors, the bank can easily ignore the views of its customers about how their money should be invested.  Customers just have to trust the bank not to do anything too stupid with their money.

Even where financial intermediaries aren't involved, the views of small or minority shareholders in a business represent  little more than an embarrassing five minutes of question time at the annual general meeting.

What we have ended up with is a form of capitalism in which shareholders aren't able to execute their rightful authority over the businesses they own.  This is instead the preserve of a self-perpetuating top management elite.  They give themselves big bonuses, reward themselves for failure, appoint their sons, daughters and colleagues to key roles and run companies generally for short-term gain.

That is fundamentally why we got ourselves in such a mess in 2008 - the elite didn't care about risk management or the long-term health of the businesses they presided over.  That was the shareholder's problem, not management's.  Incredibly, we have a system in which management are handsomely rewarded if they succeed and a little less handsomely rewarded if they fail.  The worse that can happen to the management elite is that they could lose their jobs (in which case they just move on).  Shareholders, on the other hand, get to share some of the upside with managers but wear all of the downside by themselves.  Strangely enough, Marx appears to have partially achieved his dream;  Labour (admittedly of the highly paid variety) has triumphed over Capital.


Having mentioned Marx I now need to quote Lenin:  What is to be done?

Put simply, shareholders need to be given back control over the businesses they own.

One way of doing this would be to enhance the power of minority shareholders.  In a national democracy the majority is given the right to rule provided that they commit to respecting certain well-defined minority rights.  The economic democracy of corporate governance should be no different.  Minority shareholders should be able to veto certain decisions of the majority shareholders where these would be to the long-term detriment of the company.  Where majorities take decisions that benefit them but are to the detriment of minorities, them some compensation should be provided. Minorities, no matter how small, should have board representation.

Another idea would be to look through the balance sheets of financial intermediaries to the real capitalists (depositors, unit-holders, policyholders etc).  Financial intermediary management should exercise voting rights on the boards of other companies in line with the wishes of their customers and in proportion to the amount of capital furnished by each.

Let me give a simple example.  Suppose mutual fund A has shares in company B of 80, and that company C (which administers fund A) has shares in B of 20.  Suppose further that fund A only has two unitholders, D & E. and that D owns 75% of the units in A while E owns 25%.

Under our current form of capitalism, C gets to vote all 100 of the capital, even though 80 actually belongs to someone else.  What's worse, they don't have to consult the people who actually own the 80.

What should happen is that C's position on any particular issue where it is voting on behalf of the mutual fund should be an appropriate mix of its views and those of the unit holders.  In the example above, D's views would have a weight of 60 (75% * 80), while the views of C and E would both have a weighting of 20.

Obviously in practice company C can't go running off to seek the advice of unit-holders every time it needs to vote the shares held by the fund, however it could ask unit-holders to submit a detailed annual survey containing their views on executive remuneration, risk management, strategy etc..  These views would then be merged into a policy statement which the administration company C would be compulsorily guided by when voting the shares.  For example, using such a mechanism, the underlying shareholders could impose maximum limits on derivate investments, or insist that the bulk of top executive remuneration is earned out over the medium to long term.

Why is this all so important?  Because I believe that empowered shareholders would have curbed some of the excesses (in remuneration, risk appetite) that we saw in the lead-up to September 2008, and will in the future improve the quality of company management.  At the very least, if something goes wrong, they will have the 'satisfaction' of knowing that it was due to their decision making, not that of the (largely unelected) management elite.

1 comment:

  1. Interesting post... I think the best thing about this crisi is how left and right blur, and hopefully we will replace them with other, better concepts.

    To empower shareholders sounds like an idea, but wouldn't it in practice mean more power to the people not involved in finance over the financial sector? Socialism without politics kind of...

    Capitalism is so much more than liberalism. What is outstanding about western countries is not how free stakeholders (e.g. shareholders) are to act, but how families manage to kkep wealth within their ranks through hundred of years. There is a financial class, that is currently running the business, andconfronting them will not be an easy political task.