Shareholder value is no longer everything

Shareholders are not the only stakeholders of a bank or a financial institution. Depositors, creditors, employees and counterparts are also adversely affected in the event of failure of an entity 

You are not here merely to make a living. You are here in order to enable the world to live more amply, with greater vision, with a finer spirit of hope and achievement. You are here to enrich the world, and you impoverish yourself if you forget the errand – President Woodrow Wilson

The topic of the article was borrowed from the statement issued by the Business Roundtable of the USA in 2019, emphasising that companies must invest in their employees, protect the environment and deal fairly and ethically with their suppliers. They stated advancing only the shareholder interest needs to be changed. 

Last year (2020) the 50th anniversary of Milton Friedman’s statement regarding the role of a corporate was also celebrated. In terms of his statement the social responsibility of business is to increase its profits and managers are supposed to conduct the business in accordance with the owners’ ideas. This proposition presented by Milton Friedman is very similar to the Agency theory which advocates the shareholder supremacy. The Agency theory has received a prominent attention in discussions pertaining to the theoretical frameworks of corporate governance regimes. 

After a half a century since Milton Friedman’s proposition, there are arguments as abovementioned that this narrow approach of ‘stockholder-centred theory’ has led to severe costs to society. There is a growing consensus for the redirection of corporate objectives towards more purpose-driven principles that will protect the interests of all stakeholders. These opinions are applicable to all body corporates irrespective of the nature of their businesses. In the said context, this article will emphasise the importance of redefining the institutional purpose of financial entities to be seen significant in rapidly evolving corporate orthodoxy.

Danger of short-termism

 During the Global Financial Crisis (GFC) in 2009, it was revealed that institutional investors were instrumental in speeding up the crisis by pressurising firms to focus on short term profits. Investors who were feeding assets price bubbles with a herd-like mentality was labelled as ‘short-timists’. Remuneration and incentives for managers had also been tied up with excessive risk-taking. Consequently, bank managers were persuading short-term profit goals disregarding long-term sustainability of their firms. The Agency theory attaches priority to shareholder profit maximisation over long-term resilience of financial systems. Systemic risk was, therefore, a huge concern during the GFC, and it is an issue at present as well in many jurisdictions. 

Shareholders are not the only stakeholders of a bank or a financial institution. Depositors, creditors, employees and counterparts are also adversely affected in the event of failure of an entity. Although regulatory reforms have been introduced after the GFC, in many jurisdictions with a view to preventing similar financial turmoil, no attention has been paid to change the underline theory of corporate governance structures of banks. If the shareholder centric approach is still in the prominent place, it will be difficult to safeguard the rights and interests of aforesaid other stakeholders. While ensuring shareholders reap sound returns for their investment, attention needs to be paid to rights and interests of other constituencies as well, striking a delicate balance between those prime objectives.

Financial system stability as a key stakeholder

More importantly, financial systemic resilience itself should be recognised as a stakeholder of a financial entity. Otherwise, when managers are still stressing shareholder value at the expense of other stakeholders’ systemic stability will also be vulnerable to short sighted and narrow conceptions of corporate objectives. If the corporate governance system is weak and poor, the particular financial entity will fall into fragile status increasing financial intermediation cost, hampering financial inclusion, losing employment opportunities and increasing inequality. 

It can be argued that in order to convert the said vicious cycle into a prosperous cycle institutional purpose of banks need to be redefined, based on a novel corporate governance theory. The GFC vividly exemplified the number of risks that were required to be borne by all stakeholders of banks, including the ‘entire financial system,’ real economies, treasuries and tax payers.

According to the other main traditional corporate governance theory i.e., Stakeholder theory, bank managers should have wide stakeholder orientations instead of narrow shareholder orientation advocated under the Agency Theory. In terms of the definition presented by Freeman, stakeholder means any group or individual who can affect or is affected by the achievement of a corporation’s purpose. The GFC revealed that the greedy behaviour of banks creates adverse impacts on the interests of aforementioned parties. 

Accordingly, the stakeholder theory provides a conducive framework for designing the structure and functions of a firm that is cognisant of the myriad of parties who expect several and sometimes diverging goals. This conducive element can be leveraged to design a novel corporate governance theory which recognises the ‘financial system stability’ also as a stakeholder, to build a robust governance structure of financial institutions. 

Regulatory reforms without such fundamental change of the corporate governance theory will make it difficult for managers to deviate from old institutional purpose of shareholder profit maximisation. A support can be drawn from the concept set forth by Sir Adrian Cadbury when introducing the first Corporate Governance Code of the UK, to justify the said suggestion of new governance theory. 

He states that the corporate governance is aiming to align as nearly as possible the interests of individuals, corporations and society. Since individuals, corporates, communities and reals economy was badly affected due to the crisis spilled over from financial system during the GFC, it is a rightful thing to list the financial system stability as a stakeholder under the novel stakeholder theory. It can be argued that if the financial system resilience is in place, financial soundness of firms will be ensured, and interests of affiliated stakeholders will also be protected. 

Accordingly, the shareholder centric approach under the Agency theory and novel corporate

governance theory which recognises financial system as a key stakeholder will be mutually reinforcing each other. It is a myth to say that complying with regulations applicable to protecting stakeholders of banks other than shareholders will lead the entity towards bankruptcy. It will lead to bring long-term sustained prosperity to everyone. It is time for investors also to understand this phenomenon.

New institutional purpose towards inclusive capitalism

Inclusive capitalism is fundamentally about delivering a basic social contract comprised of relative equality of outcomes; equality of opportunity; and fairness across generations. Different societies will place different weights on these elements in their socio-economic development agendas. According to the ‘inclusive stakeholder approach’ introduced by Professor Lynn Stout, the purpose of corporation needs to cover corporate, social and environmental responsibility. Based on this premise we can get financial institutions to ensure resilience of the system in which they operate. 

Financial systemic stability has been an objective for regulatory authorities throughout the history. However, since business decisions of banks are taken by their board of directors and key management persons, they should be vested with the responsibility to assess the impact of their decisions on wide financial system. Prescriptive enforceable corporate governance rules can be imposed to get financial entities to consider macroprudential impact of their business decisions. It may lead to reduce systemic risk and mitigate moral hazard effects as well.

Professor Stiglitz states that the post-pandemic world needs to be a greener, more knowledge based and societies with greater equality. Banks and other financial institutions can design strategic projects to meet the credit needs of the communities in which they operate instead of mere philanthropy expenditures or Corporate Social Responsibility (CSR) projects. That will lead to a better reputation which has positive effects on Corporate Financial Performance. 

Research has revealed that institutional investors may be more attracted to investing in banks with a better social reputation. Priority should also be attached to product responsibility to win consumer confidence. It would be prudent to design a more relational business model, in which real needs of customers are considered by introducing appropriate products and services offered with better advice and transparent information. Developing skills of employees to cope with evolving market paradigms with digitalisation and building capital buffers are very important tasks to undertake in terms of a new corporate objective for the financial services industry. 

Marc Carney has also stressed the importance of promoting the focus on financial services industry on inclusive capitalism. Market fundamentals, which are the parameters of capitalism, did not work as expected, and financial crises have occurred in the context of light touch regulatory approach in jurisdictions such as the UK. Efficient market hypothesis and rationality were failed to deliver the desired outcomes during the GFC, and greedy behaviours of banks dragged the fundamentals of capitalism to extreme extents. Redefining the institutional purpose of banks will, therefore, be a paradigm shift which requires to validate the inclusive capitalism. 

Role of the financial institutions to mitigate inequality

The COVID-19 global pandemic revealed systemic flaws related to wealth distribution, healthcare access and disruption in ecosystems. Big or small all countries in the world are facing pandemic-induced severe economic challenges. According to Pralhad by engaging with the ‘underserved-consumers’ at the bottom of the pyramid in market development, it is possible to achieve ‘entrepreneurship on a massive scale’ that will uplift the poor and yield profits to the firms that engage in what becomes a ‘win-win’ proposition for business and society. 

It highlights a significant perspective of proposed renewed corporate objectives of financial institutions. The consequences of health crisis have urged to expedite the renewal of institutional purposes of all body corporates. In fact, banks were required to function as responsible corporate citizens during the health crisis by distributing government subsidies to affected parties and assisting the communities in which they operate.  

In the meantime, emphasis is made on climate economy, for which right carbon price, green stimulus and a just transition have been recognised as key requirements by the IMF. In redefining the institutional purposes of financial institutions, it will be essential to focus on sustainable finance and digitalisation which is transforming economies and lives rapidly.

It can be argued that financial institutions can play a pivotal role to smoothen the edges of capitalism to reach sustainable development goals, inclusive development and shared prosperity by redefining their corporate objectives. It will be important to take their contribution towards inclusive development to measure the firm value instead of share price. Implementation of new corporate purposes of financial institutions which covers the stakeholder inclusivism needs to be underpinned by prescriptive and enforceable corporate governance rules. Safe and sound financial institutions can contribute to financial deepening, financial sector development, enhancing financial inclusion and thereby mitigate inequality.

It is noteworthy to quote Christine Largarde’s statement here: “We can identify the true purpose of finance. Its goal is to put resources to productive use, to transform maturity, thereby contributing to the good of economic stability and full employment—and ultimately, to the wellbeing of people. In other words—to enrich society”. 

Profit maximisation Vs value maximisation

One may argue that aforementioned social responsibilities need to be handled by the government and not the private sector. It is true that corporate entities are required to contribute to the economic by enhancing their productivity. Financial firms can extend their contribution towards development by helping to move the wheels of economy. It can be possible if only the sustainability of financial firms is ensured. As mentioned earlier, in the event of failure of financial institutions there will be a huge economic and social cost. 

Professor Raguram Rajan postulates that by taking maximisation of the value of firm and investment as the corporate objective, management can inspire greater trust in key constituents and offer more socially acceptable picture of the corporation and also maximise the value of the firm. This strategy can be followed by bank and other financial entities as well. Maximising not just the economic value but also societal value will enable financial institutions to win public trust, which is essential for smooth financial intermediation function. 

Rajan further states that as the technology is bringing the whole world to us, the solution to some of our problems is to embrace what is near – the community. Reviving what is near is, therefore, of essence to ensuring our humanity. In the circumstances it is very vital for financial institutions, especially systemically important banks to design their corporate objectives including ways and methods to empower the communities in which they operate. It will lead them towards the aforementioned win-win situation which can be seen in the context of prosperity and stability. Short-term business agendas need to be revisited to capture long-term benefits for wide stakeholder groups.

Sustainability as the key norm

Year 2021 is considered a year for recovery. However, the complex issue of ‘inequality’ has become even stronger to spread its dark shadow over almost all the aspects of human lives. Therefore, the year 2021 presents a great challenge to achieve a more equitable and fair society not only in emerging economies, but also in advanced economies. This article highlighted role of financial sector towards addressing inequality to achieve a just society by deviating from traditional shareholder centric approach and focusing on wide stakeholder orientation. 

Recognising financial systemic resilience as a stakeholder will be a crucial element in this novel corporate purpose approach. Instead of imposing a mere moral obligation to this effect there needs to be efficient enforcement measures in the instances of acting in contraventions of the requirement to preserve systemic stability. Regulatory authorities need to take prompt corrective action to mitigate harmful impacts on systemic resilience stemming from wrongful corporate 

behaviours. 

It is also important to have safeguards in place to avoid unnecessary political interferences in affairs of state banks. Ensuring the fairness and integrity in financial services industry should also be a vital element of responsible banking. Investors need to understand the benefits that may bring a sustainable business model during good and bad times instead of insisting profit making within short-term horizons. Correct blend of profit guide and public purpose will make the banking a more dignified profession. Ensuring a comprehensive risk management strategy which recognises recovery planning as an ongoing task is in place, will make handling inherent risks in a realistic and responsible 

manner.