“Are Markets Safer Now?” is the title of a panel I’m looking forward to attending Wednesday at the World Economic Forum in Davos. Five top financiers and financial experts, including hedge funder Paul Singer and Stanford professor Anat Admati, author of the “Banker’s New Clothes,” will duke it out over whether the financial system is any more secure now than it was in 2008. I suspect that Admati, with whom I spoke with for my recent “How Wall Street Won” story, will agree with my take – it isn’t.
I won’t recap that argument, which basically deals with the problems since 2008, here. Instead, I want to offer three deeper, historical reasons for continuing financial sector instability, and how they’ve led to a system in which business now serves banking, rather than the other way around.
The move from a partnership structure to a public company structure. Banks used to be organized like white shoe law firms—they were a collection of individuals who divided the profits of the business, but also had personality responsibility for its losses. With the move to a corporate structure, that individual responsibility was lost. While the reason for taking outside investors and making banks bigger was often to increase lending, and thus help Main Street, the practical result was ultimately to increase leverage (why not take more risk when you aren’t personally responsible for it?) and destabilize the system. It’s yet another argument for making banks smaller and dividing them along business lines (we’re not lacking capital in the financial world these days, but high quality, truly client oriented advisory services and top-tier research – I suspect boutique institutions offering more of that would do a brisk business).
The cult of shareholder capitalism. We’ve come to see shareholders as the sole “owners” of businesses, but there’s an argument to be made that their claim to true ownership of a business is weak, which is why they have to be awarded voting rights in the first place. Shareholders certainly deserve an important seat at the table, and can play a key role in policing management, but they also have a strong impetus to encourage decisions that boost share price above all else – and that can lead to short termism (since the 1990s, the rise of share buybacks, which almost always bolster stock prices, has coincided with a decline in R & D spending in corporate America). The Street pushes this short termism, and rewards it with higher share prices (that is, until a lack of investment begins to erode corporate market share).
The fact that corporate compensation is based largely on stock prices. Even if we shifted to a Germanic system of “stakeholder capitalism” in which a broader group – labor, and civic leaders, as well as management and shareholders – were considered “owners” of a business, to the extent that everyone gets compensated with stock options (particularly in packages that vest quickly, and have no claw back provisions for bad decision-making) the problem of short-term thinking at the expense of long-term investment remains.
A smart source recently pointed out to me that capitalism, which always awards a much greater share of the global pie to owners rather than laborers, only works if the capitalists invest in production, thus creating more jobs and giving some of the pie back to labor. These days, many of them are sitting on cash, and/or giving it back to themselves. Seems like a recipe for instability to me.
