Shareholders will save the banks

Is it time to blame shareholders for the credit crunch? I’ve tried thinking through blaming nearly everyone else and was surprised to see that for some reason I’d left the firms’ owners off the list. That’s weird, since I normally assume that shareholders are the ultimate arbiters of a firm’s values.

To start not quite at the beginning. I often argue that firms don’t really have any responsibility except to their shareholders, the people who own them. I only half mean this, but it’s a good astringent to apply to all the woolly guff about Corporate Social Responsibility.

The assumption is that it’s the shareholders who are at risk so they will discipline firms in directions which suit them, and good luck to them. If you don’t like it, start a firm of your own or invest somewhere else.

The trouble is that some firms pose a systemic risk to the wholly economy. That would be banks, at least as we know them.

One can imagine shareholders making all sorts of demands of a bank’s managers and the managers acceding to these and running the bank into the ground but neither party much minding because they’ve all salted away enough in the good times not to mind much when the game ends. Or: the shareholders send the wrong signals for years, the bank collapses, and the shareholders wish they’d thought of a different strategy. Or: the shareholders are big institutions who send the wrong signals and the bank collapses but it’s the institutions’ millions of pensioners who suffer.

Oh, and alongside any of these scenarios there may be masses of social misery as the banking system takes a knock. And state involvement as the system is propped up.

Elements of these pictures have just unfolded of course.

But one should still try to get the shareholder centre stage. Ideally, we’d have a banking (and general nexus of financial institutions) such that any failures would impact overwhelmingly on shareholders – and limited to them. That would imply that you’re aiming at a nexus of financial firms which is relatively immune to contagion.

The point is that one wants a system in which banks aren’t likely to fail and it doesn’t matter if a few do. I take it that regulators can achieve this but only at likely great cost in moral hazard and clunky interference.

As we redesign the regulatory framework it seems logical to aim at putting the risk and discipline back into the hands of shareholders and to limit the risk this entails by also ensuring that firms are required to understand and advertise the risks they are taking so that customers and shareholders know what they’re getting into.

The merit of having shareholders centre-stage is that issues of short- or long-termism, and general riskiness are robbed of their moral dimension. If shareholders want incredibly risky short-term businesses, they can have them. If they want to steer away from the casino and toward the utility, that’s fine too.

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Publication date

07 February 2009