Thursday, 10 April 2008

Ruth Lea's wrong answers

Ruth Lea, former head of policy at the Institute of Directors, has an article on Comment Is Free today about the credit crunch. Basically it is, as you might expect, a call for restraint in dealing with current market turmoil. It trots out the same line advanced by The Economist recently that we should be wary of over-reacting and killing off innovation and entrepreneurialism in financial markets.

Although there is a nugget of truth in here - I do think financial innovation has the potential to be a very good thing for working people if it helps share risk - both articles read like unthinking narratives. There is no acknowledgement that regulation can actually create new markets, or play a positive role in solving probelms. Instead regulation is posed as stifling innovation.

In addition I don't think the Comment Is Free piece is right to apparently place equal blame for Northern Rock's failure on the bank's board and the FSA. She's right to say that Hector Sants has admitted that the regulator could have done much better, but did she miss the bit where he said that even if they had been more on the ball it still might have made no difference. In my opinion suggesting equal blame takes you down the road of expecting regulators to pre-empt problems at companies that even their own boards don't spot.

But the bit in Ruth Lea's article that really had me shaking my head is this:

Inevitably, the combination of banking bailouts and chief executives walking away with generous payoffs, leads to calls for more regulations. But, in Britain at least, this should be resisted. We have regulations aplenty. More regulation risks damaging innovation and entrepreneurial activity that are vital to the success of the City of London, a vital part of the British economy.

Instead boards of financial institutions must focus on the long-term prosperity of their businesses and ensure that remuneration packages for key employees balance short-term, performance-related reward with longer term business objectives. These are corporate governance issues that should be left to boards and shareholders.

As is probably pretty clear, I'm not big on ideological approaches to policy, and I think this has often been a big failing of the Left. But the Right can fall for illusory ideological answers to problems too. And one theoretical fallacy they seem to repeatedly fall for is the idea that shareholders act like owners, and as such are best placed to resolve governance failings.

Shareholders ought to act like owners, because it is in their financial self-interest to do so, but most typically don't. I think this is partly because they aren't investing their own money, and maybe also because a key group of 'shareholders' - the fund managers - are culturally desensitised to high pay (because it is so prevalent in their world). These guys (and they are normally guys) are principally traders, not owners. A handful of managers try and play the ownership role properly, but they are easily outnumbered by those who don't.

The result is that although there is a lot of sound and fury about executive pay each AGM season, actually very few companies face serious opposition. The most recent stats I have found are for the 2006 proxy season, when the average vote against a remuneration report was... 4%. I can't see how we can avoid concluding that 'shareholders' are quite happy with executive pay as it stands. Shareholder votes on exec pay are principally an exercise in rubber-stamping decisions already taken by management. Therefore expecting shareholders to address the pay-outs related to sub-prime failings seems a bit of a forlorn hope (though notably some investors outside the UK are having a go).

If I was being cynical I could read this as a case of advancing a reasonable-sounding 'solution' that it is known won't have any meaningful impact. However it's probably much more simple - an ideological belief in how the company-shareholder relationship should work, that overlooks real-life practice.

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