Why Excessive Risk-Taking Is Not Unexpected
2009 , 1:30 pm
Leo E. Strine Jr. is vice chancellor of the Delaware Court of Chancery.
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.
When the marketplace
presents opportunities for corporations to generate immediate gains through
transactions structured so the profits are taken up front and the risks are
perceived as minimal, corporations seeking to please a short-term-focused
market are likely to seize them. Risks might be sold immediately to others,
or theoretically contracted away through arrangements that look like
insurance but don’t involve counterparties meeting the standards that apply
to insurance companies. Or perhaps the risk is structured to kick in several
years down the road.
Likewise, when institutional
investors with strong voting clout encourage corporations to increase
leverage in order to engage in stock buybacks, increase dividends or reap
higher trading gains, responsive corporate boards may leave their
corporations without adequate capital to weather tough times, times when
many of the proponents of leverage are likely not to be around as
If an industry senses that
United States Treasury has its back in the event that risky activity
threatens the industry’s health, its leaders may respond even more freely to
these market incentives, because they view the industry as having a form of
insurance from the taxpayers. When the industry and its leaders have also
designed compensation systems that reward managers for generating short-term
profits through risky activity — systems often implemented with the
encouragement of investors desiring to give managers a strong incentive to
pump up stock prices — managers who might otherwise be more focused on the
long-term health of their employers are encouraged to go hellbent for
leather for immediate gain, too.
During the last 30 years, it
is indisputable that: (1) regulatory standards have been greatly relaxed,
giving the financial industry free rein to leverage itself to the hilt and
to engage in a wide range of speculative and increasingly opaque, complex
activities, often without rigorous safeguards; (2) the power of stockholders
to influence the composition of corporate boards and the direction of
corporate strategy has been markedly enhanced; (3) institutional investors
who hold stocks, on average, for a very brief period of time and are highly
focused on short-term movements in stock prices have become far more
influential and prevalent; and (4) “pay for performance” compensation
systems were implemented to align the interests of managers with
stockholders by giving managers incentives to pump up corporate profits in a
manner that will increase the corporation’s profits and stock price
immediately, rather then durably.
Distilled down, what is most
critical is that robust prudential regulation protecting society from risky
corporate activity abated, precisely when corporations faced increasingly
strong pressures to engage in much riskier endeavors in order to generate
short-term results. In the financial sector, this potent cocktail was chased
by several governmental interventions to rescue the industry when its
“innovative” activities threatened its health, a course of conduct that
suggested that the financial industry could take risks other industries
could not, because it had a de facto form of federal insurance.
There is, of course, much
that is simplified about this description. But, it is in the main true. And
it suggests that policy makers need to be mindful of the relationship
between the power of the stock market to influence corporate policies and
the strength of prudential regulation. Because even diversified long-term
stockholders are likely to have an appetite for risk that exceeds what is
socially prudent, there will always need to be strong rules of the game to
govern industries whose failure poses socially unacceptable risks.
There is no escape from the
fact that although corporations are sometimes seen as owned by those who own
their equity and elect their boards, the actions of corporations affect a
broader range of constituencies, including workers, creditors, consumers and
society more generally; no sensible regulatory system can ignore that fact.
The difficulty is compounded
when those who directly influence public corporations are not primarily end
user investors focused on the long term and keenly worried about excessive
risk — think workers who must invest in mutual funds for retirement — but
far more likely to be financial intermediaries whose investment horizons are
often less than a year.
Strong regulatory standards
are indispensable, not simply for society, but also for end-user long-term
investors themselves, who bear the long-term costs of corporate idiocy.
Therefore, if the correct
policy balance is to be struck regarding regulation of the financial
industry and other industries that pose large systemic and societal
externality risks, policy makers cannot continue to avoid the obvious
alignment problem that now vexes our corporate governance system.
Most Americans invest with a
rational time horizon consistent with sound corporate planning. They invest
with the hope of putting a child through college or providing for themselves
in retirement. But individual Americans don’t wield control over who sits on
the boards of public companies. The financial intermediaries who invest
their capital do. These intermediaries have powerful incentives — in
important instances, not of their own making — to push corporate boards to
engage in risky activities that may be adverse to the interest of long-term
investors and society. That is, there is now a separation of “ownership from
ownership” that creates conflicts of its own that are analogous to those of
the paradigmatic, but increasingly outdated, Berle-Means model for
separation of ownership from control.
Unless these incentives and
conflicts are addressed, it should be expected that corporate boards will
continue to face strong pressures to manage their enterprises in a manner
that emphasizes the short term over the long term, and that involves greater
risk than is socially optimal. As a result, more stringent than optimal
prudential regulation will have to be in place to bar the financial sector
from taking risks that endanger society as a whole, rather than simply the
capital of their investors and the employment of their employees.
There is nothing new about
the insight that the more incentives businesses have to generate short-term
profits, the more likely it is that they will engage in excessively risky
activity, especially if they believe that the risks will be borne by others
if they come to fruition. We simply have another hard-learned lesson to
point to about the costs of ignoring these realities.
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.
Ideally, we want a system
where corporate boards are highly accountable and responsive to their
stockholders for the generation of sustainable profits. But for that policy
objective to be achieved, stockholders themselves must act like genuine
investors, who are interested in the creation and preservation of long-term
wealth, not short-term movements in stock prices. So long as many of the
most influential and active investors continue to think short term, it is
unrealistic to expect the corporate boards they elect to strike the proper
balance between the pursuit of profits through risky endeavors and the
prudent preservation of value.
Leo E. Strine Jr., vice
chancellor of the Delaware Court of Chancery, is also the Austin Wakeman
lecturer in law of
Harvard Law School, an adjunct professor of law at the
University of Pennsylvania and Vanderbilt law schools, and a Crown
Fellow with the Aspen Institute.