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Opinion

Beneath The Big Short

Chris Halburd / Feb 2016

Image: Wikimedia Commons

As the credits started to roll on the new film starring Brad Pitt, Steve Carell, Ryan Gosling, and Christian Bale, “The Big Short”, based on the book of the same name by Michael Lewis, I was left with the sense that, in some ways, we have learnt comparatively little from the events leading up to the Global Financial Crisis. The film does an excellent job of explaining some of the more arcane financial shenanigans that were being engaged in on Wall Street at the time but these were only the manifestations of an underlying ideology and unless we address that ideology history may well repeat itself.

The key to understanding the problem is to appreciate that businesses, such as banks, are not legal entities themselves. They are, for the most part, made up of corporations and increasingly it came to be understood that the purpose of a corporation was to maximise shareholder value. The easiest way to measure success in that regard was to closely scrutinise the corporation’s share price on an ongoing basis.

In order to encourage company executives to drive up the share price it became common not just to link remuneration with the share price but also to pay large portions of any remuneration package in shares or options. The carrot thus provided it only remained to deploy the stick in the form of the, aptly named, “market for corporate control”. In short the latter meant that underperforming companies, those whose share prices the market deemed ought to be higher, could be taken over and new managers put in place.

The practical effect of this was that since banks could make much more money developing and trading in ever more complex derivatives than they ever could by lending to the true engine room of the economy, small to medium enterprises, that this exactly what they did. Setting aside those that engaged in illegal activity, it is difficult to place too much blame on the bankers themselves who were told that if they maximised value for shareholders they would be handsomely rewarded and if they did not they would be out of a job.

This notion that the purpose of a corporation is to maximise shareholder value is a relatively recent development in the long history of the company. Originally, in places like the United Kingdom, it was simply not possible to set up a company unless it had, what was deemed at the time to be, a social purpose such as digging a canal to provide water to a city. The early companies were often limited in how big they could be, thus they simply could not be “too big to fail”. They could also be limited in how long they lasted. This had the effect that if they were to harm society their charters need not be renewed and they would cease to exist. They could not own shares in other companies and they did not have limited liability. This last point meant that shareholders had a real interest in ensuring that companies in which they invested caused no harm as they went about their business because, if they did, the shareholder might have to make good any loss suffered as a result of the corporation’s actions.

Today we have a situation where companies last forever. There is no limit on how big they can be and many have market capitalisations larger than some countries. Companies routinely own shares in other companies and the modern multi-national corporation, with its ability to aggressively transfer price and thus elect how much tax to pay and where to pay it, is made possible by businesses being made up of a series of related corporations incorporated in different countries. Companies no longer need to have a social purpose, merely a legal one, and shareholders need no longer concern themselves with harms caused by the companies in which they invest unless those harms impact on the share price.

There is a growing international debate around whether or not the so called duty to maximise shareholder value exists in law or whether it is merely a social norm. To circumvent this debate new corporate forms are being developed such as the Benefit Corporation which now exists in 30 States of the United States including Delaware which hosts well over half of the Fortune 500. These corporations specifically do not have shareholder value maximisation as their purpose and so, if a bank were a Benefit Corporation, the imperatives to engage in financial engineering rather than lending to the real economy described above would not apply to them. Just before Christmas the Italian Parliament led the way in Europe by enacting Benefit Corporation legislation and it is hoped that this will pave the way for similar legislation across the EU.

If society allows the corporations that operate banks to continue to function on the basis that their primary purpose is to maximise value for shareholders we will have no one to blame but ourselves should these corporations become the architects of another financial crisis.

 

Chris Halburd

Chris Halburd

February 2016

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