Why Excessive Risk-Taking Is Not Unexpected

October 5, 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 stockholders anymore.

If an industry senses that the 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.