Strine on Excessive Risk

Delaware Vice Chancellor Leo Strine has a provocative op-ed in the NY Times Dealbook blog, in which he discusses the problem of excessive risktaking by boards during the run up to the financial crisis.

Whatever the possible causes of the recent financial debacle, it seems clear that there is one cause that can be ruled out: that the directors and managers of the failed firms were unresponsive to investor demands to take measures to raise profits and increase stock prices.

Rather, to the extent that the crisis is related to the relationship between stockholders and boards, the real concern seems to be that boards were warmly receptive to investor calls for them to pursue high returns through activities involving great risk and high leverage. Indeed, the recent financial industry debacle is perhaps most surprising for its predictability in light of mundane realities accepted by social scientists of the center left and right.

It is well known that businesses aggressively seeking profit will tend to push right up against, and too often blow right through, the rules of the game as established by positive law. The more pressure business leaders are under to deliver high returns, the greater the danger that they will violate the law and shift costs to society generally, in the form of externalities. In that circumstance, if the rules of the game themselves are too loosely drawn to protect society adequately, businesses are free to engage in behavior that is socially costly without violating any legal obligations.

Moreover, the ability of any particular firm to resist imitating the overly risky, but law-compliant behavior of competitors will be compromised to the extent that managers face criticism or even removal for not keeping up with so-called industry leaders whose high, short-term returns have pleased a stock market filled with short-term investors looking for alpha.

Similarly, when power and influence over corporate activities is exerted by those whose primary interest is immediate gain and who have little or no intention to stay invested until the full costs of risky activity are borne — e.g., certain institutional investors who invest the money of others — corporate managers will have an incentive to be responsive to their demands.

(Notice that this is an argument for board-centric forms of corporate governance, such as director primacy, which seek to constrain shareholder power.)

Personally, I think the problem was not excessive risk taking (I'm not even sure how one would measure whether risks are excessive). I think the problem was lousy risk management practices.

Assuming Leo's right, however, what are we to make of the argument? Strine contends that:

In shaping the future, policy makers might therefore focus on two key objectives: re-instituting sound prudential regulation over financial institutions critical to the overall well-being of our capital markets and economy, and implementing policies that focus stockholders and boards on the objective of having corporations produce wealth in both sound, durable fashion.

Strine does not expressly address the question of whether these policies should be implemented through the vehicle of corporate law. I suspect, however, that Strine would find much with which to agree in Gordon Smith's wonderful paper The Dystopian Potential of Corporate Law.

Smith argues--I think quite correctly--that "changes in corporate law cannot eradicate poverty or materially change existing distributions of wealth, except by impairing the creation of wealth. Changes in corporate law will not clean the environment. And changes in corporate law will not solve the labor question. Indeed, the only changes in corporate law that will have a substantial effect on such issues are changes that make the world worse, not better."

When we ask directors to serve multiple masters--shareholder wealth maximization, the public good, the economy, and so on--we invite chaos. We also invite the to juggle their masters so as to camoflauge self-interested decisions. (For more on that point, see my paper on corporate social responsibility).

We want directors to maximize shareholder wealth within the constraints of positive law. If we are worried about corporate policies that generate externalities in the form of systemic risk to the economy as a whole, then change the relevant legal regimes. But don't change the corporate law duties of directors.

Comments

[ohwilleke]

This sounds like a straw man argument. This gist of the argument, well stated, is that management, which faces great upside gain, and little downside loss has incentives different than those of shareholders who have the potential to lose all of their investment if the company loses money, and have a generally unleveraged upside gain. Thus, management is more inclined to take risks that pose a risk of a loss than shareholders. If this is true, then greater shareholder control of management through more effective shareholder controlled boards should reduce risk taking.

One of the biggest empirical data points that supports this theory is that mutual companies in industries that compete with publicly held investor owned companies generally and historically are less prone to take action involving downside risks.

Another is that closely held banks (where effective control of management by shareholders is greater) were not, on average, as prone to bad loan underwriting, a publicly held banks.

A third is that there is some preliminary evidence that entities organized on a partnership model (mostly private equity firms and hedge funds) where management has more to lose than management in publicly held firms with stock options, took smaller losses and less risky positions than publicly held firms in the Financial Crisis. A related data point is that the demise of the independent investment bank closely coincided with the widespread move of those firms from an employee ownership model to a public shareholder owned model.

[Bernard Sharfman]

I find it somewhat implausible that the corporate boards of our largest financial institutions suddenly went into a frenzy of excessive risk taking based on pressure from shareholders. Moreover, who were those incredibly effective shareholder lobbyists who influenced the boards to act in such a reckless manner? Could the culprits have been mutual funds, public pension funds, Taft-Hartleys or influential retail investors? I doubt it. Still, I believe the problem resided with the residual claimants, but with residual claimants other than shareholders. On Wall Street, tens of thousands of employees entered into large annual bonus arrangements which encouraged the pursuit of fake alpha (Professor Rajan). Such a pursuit by these residual claimants gave the appearance of earning excess returns, until the hidden tail risk was realized. When that large negative return was realized, a systemic failure occurred. So, a more plausible explanation is that the boards of these companies did not understand the risks their employees were taking, not that they endorsed excessive risk taking. Now the question is why do these compensation arrangements continue to persist, given that the fake alpha story has been disclosed, and what needs to be done about it so a systemic failure does not occur again.