Why Financialized Corporate Governance Works Poorly

Anat R. Admati is George G.C. Parker Professor of Finance and Economics at Stanford Graduate School of Business. This post is based on Professor Admati’s recent article, published in the Journal of Economic Perspectives.

Corporate finance textbooks describe shareholders as the owners of a corporation and teach future managers how to create “shareholder value.” Increasing shareholder value is generally seen synonymous with increasing “shareholder wealth” as measured by the market value of their shares. The academic literature views conflicts between managers and shareholders as the main challenge of corporate governance. Common practices to align managers’ interests with those of shareholders include paying managers with stocks or options and rewarding them based on financial metrics such as (accounting) profits and return on equity.

Until about a decade ago, my teaching and research reflected the standard view of corporate governance described above. However, the financial crisis of 2007-2009 led me to look more closely at financial corporations and consider their governance and the relevant laws and regulations that affect them. My conclusion after about nine years of studying the issues is that the financial system is unsafe and inefficient and that the dangers and distortions are the result of persistent governance and policy failures. A key problem is summarized by “it’s the politics, stupid,” a statement included in a recent Economist piece calling on economists to take politics into account if they want to be relevant.

In years of advocating for better regulations concerning how banking institutions are funded, I have seen directly how vested interests actively create confusion and muddle the public debate and the overwhelming importance of the political economy that determines policy, i.e., the understanding, motivation and incentives of individuals in key policy positions, and their willingness to engage and act in the public interest when doing so is inconvenient. Despite the devastating financial crisis, the relevant rules have remained poorly designed, inadequate, and in some cases counterproductive, and “too big to fail” remains a problem. The messy effort at reform allows everyone to maintain his or her favorite narrative. Because the issues appear complex and confusing, the enablers of this dangerous and inefficient system can remain willfully blind and continue to obscure the situation with flawed claims. (Various related writings are linked from this website and observations about the many enablers of this situation are summarized in a paper I wrote recently entitled It Takes a Village to Maintain a Dangerous Financial System.)

These experiences have led me to re-examine the standard view of corporate governance that focuses on “shareholder value creation” as the desired goal. Whereas the financial system provides extreme examples of the distortions that such a focus can give rise to when combined with policy failures, similar issues arise in many other settings in which the interaction between governments and corporations produces inefficient outcomes. I discuss some of my observations in a new article entitled A Skeptical View of Financialized Corporate Governance, which appeared in the current issue of the Journal of Economic Perspectives as part of a symposium on the modern corporation (JEP publishes nontechnical articles of about 7,500 words aimed at general economists.)

The logic of financialized corporate governance is captured in Milton Friedman’s claim in his well-known 1970 article in the New York Times that the social responsibility of business is to “make as much money as possible while conforming to the basic rules of society, both those embodied in law and those embodied in ethical custom.” Friedman presumes that businesses operate in an environment of “open and free competition without deception and fraud.” The underlying assumption behind his claims and the standard approach to governance is that competitive markets and the “rules of society” protect stakeholders other than shareholders. Friedman warns that corporate leaders who “pontificate” about corporate social responsibility will bring back “the iron fist of government bureaucrats.” In his view, governments only harm “free markets.” He does not discuss, however, who determines the “rules of society” and who might be able to impact those rules and their implementation.

In my article I give some reasons why financialized governance often works poorly for most shareholders. Even when shareholders appear to benefit in terms of measures of “shareholder wealth,” significant inefficiencies and harm can arise from the conflict between maximizing financialized measures and society’s broader interests, including possibly the interests of many shareholders who might also be customers, employees or just tax-paying citizens. For example, financialized governance provides incentives for biased presentations of accounting data and even outright accounting fraud that hides relevant information from investors and governments. Financialized governance practices can also lead to misallocation of resources through “short-termism” or mismanagement of risk, whose upside benefits those controlling corporations while the downside harms others, including shareholders and the broader economy.

Thus, in the name of creating “shareholder value,” corporate managers have incentives to engage in conduct that harms and endangers the corporation and its stakeholders inefficiently, as well as to lobby and influence governments, sometimes through the courts, to affect the rules and get away with such conduct. Even in well-functioning democracies, as seen most clearly in the financial sector, governments may lack the political will to design and enforce proper rules for corporations. Policymakers are not sufficiently accountable for the bad outcomes, particularly when the issues are complex and not well understood by the public, so the policy failures are difficult to see. Instead of alleviating frictions, enabling markets and contracts to work better, preventing harm at a reasonable cost whenever possible, and helping hold those who control corporations accountable, governments sometimes exacerbate governance distortions and inefficiencies by creating flawed and ineffective rules. I elaborate on some political economy issues such as regulatory capture, the effectiveness of enforcement, and cross-jurisdictional competition.

In the limited space of the article explaining my skeptical view of financialized governance, I focused on opacity, fraud, deception and mismanagement of risk, but these are not the only problems that come about when governments and corporations interact. The “too big to fail” financial institutions are not only reckless, inefficient and dangerous, but they also are able to acquire and maintain outsized market power that distorts the entire economy. Another article in the same symposium, by Luigi Zingales, focuses fully and generally on the way corporations in many industries build both market power and political power that feed on one another. Both articles raise concern over these problems and point to the importance of better public awareness. Preventing the abuse of power in private and public institutions is very important as well as challenging, because it takes on powerful forces. Improving governance and changing the status quo would require the collective action of many.

The complete article is available for download here.

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  1. Richard H Caldwell
    Posted Sunday, August 13, 2017 at 5:20 am | Permalink

    I hope your article is a harbinger of a turning tide in our collective view of the role, scope, governance, and regulation of corporations. Friedman’s “big idea” has done enormous damage ro the fabric of our society by radically accelerating the adoption and promotion of the view of society as merely a collection of amoral and atomic actors bearing no duty or responsibility to society as a whole. Fifty years on, the damage wrought upon our institutions by this paradigm is abundantly clear. Thank you for having the courage to change your mind and speak out.

  2. Eduardo Canabarro
    Posted Saturday, August 19, 2017 at 1:53 pm | Permalink

    This article is on the right track. Managers and boards have strong economic incentives to neglect the “extreme left tail” of potential outcomes. They prefer short-term gains at the expense of potentially catastrophic, yet rare, large losses. Managers and boards enjoy limited liability on the downside. Most board members are provided insurance policies against law suits. Managers are fired and get new jobs after collecting large pay checks for years. This is particularly important in financial institutions which are highly leveraged, opaque and very complex.