A slightly different Tony’s Ten Minutes this week. I have actually been reading some of the materials I get my students to read, and it got me thinking – maybe banks need to go back to the old days, before we even had a divide between shareholders and managers.
In the ifs’ MSc in Bank Practice and Management, one of the readings in the risk element of the programme is by Ohio States’ René Stulz (1996). It is one heck of a big paper covering many, many areas of enterprise risk. It is all good, but the element I found particularly interesting was on the role of incentives in risk taking and whether we should force managers to have a bigger downside stake in the firms in which they work. The paper raises some interesting point about the alignment of managers with managing enterprise risk in the best interest of shareholders.
The paper refers to the gold industry and how different ownership patterns impact hedging strategy (based on the work of Tufano, 1996). It notes that some firms hedged and others did not, and many had a selective hedging strategy. If you roughly know the likely output of your mine, and operate in a market-driven pricing regime, the choice to hedge and lock-in revenues or to ride the speculative wave is a big decision. Not hedging could mean a manager has good information that prices will rise – but why in such an open market would they have better information than other participants? Could it be that if they only have up-side incentives, and are therefore not minded to cover downside risk?#
Stulz notes (p18) “In general, the greater management’s direct percentage share ownership, the larger the percentage of its gold price exposure a firm hedged. By contrast, little hedging took place in gold mining firms where management owns a small stake.""
This is rather resonates with some arguments which have been going around that banks served society better when they were unlimited liability partnerships, so that the managers’ wealth becomes interwoven with enterprise value of the bank. Indeed, as those owners were responsible for covering losses, leverage in such firms tended to be very low; when banks shifted to publically traded limited liability firms, leverage shot up (noted even by the Bank of England’s Andrew Haldane, 2012).
So, the argument goes, enterprise risk increases as the managers’ ownership and liabilities decrease, AND they further increase if up-side-only incentives such as share options are used to encourage good performance. Therefore, should we not return to unlimited partnership structures? If we did we would hardly need risk management or an ERM function because the managers would be so risk averse they would not do things needing such scrutiny?
Well, sadly no, the unwinding of leverage positions would lead to a devastated economy (we are hooked on massive leverage, getting rid of it will take decades). Also, the reasons for the increase in leverage can only be partially put down to bank ownership. The growth in leverage also involves, and probably more significantly, other regulatory changes and indeed (more controversially), the shift from gold-based currency to fiat money.
In the real world, the few banks which still use unlimited liability structures are going the other way. Even the wonderful Pictet (a very civilised bank) and Lombard Odier & Cie have abandoned the structure (Buchanan 2013).
However, should we still consider going the opposite way and forgetting complex bonus and option claw-back regimes and simply say to managers, “right, you own this firm and are responsible for any losses” and see how they then perform…sadly, that is a rather fanciful thought. Maybe some of you would agree though????
Stultz, R. (1996) Rethinking risk management. Journal of Applied Corporate Finance, 9(3). Available at: http://www.cob.ohio-state.edu/fin/faculty/stulz/publishedpapers/Rethinking%20Risk%20Management.pdf[Accessed 8 February 2013].
Haldane, A. (2012) The Doom Loop. London Review of Books, 34(4), p21-22. Available at: http://www.lrb.co.uk/v34/n04/andrew-haldane/the-doom-loop [Accessed 8 February 2013].
Buchanan, E. (2013) Swiss private banks shed unlimited liability in historical shift, Private Banker International. Available at: http://www.privatebankerinternational.com/news/swiss-private-banks-shed-unlimited-liability-in-historical-shift/ [Accessed 8 February 2013].