What this incident demonstrates, yet again, is that these highly complex derivative strategies, when multiplied by a legion of traders, of quant analysts, each pursuing a different concept, and the competing executives who each acquire a stake in the success of their particular group, become too complex for any human being, or small group of human beings, even aided by the best information technology in the world, to manage.  Models only work until the assumptions underlying them break down, and relying upon diversification to bail you out can become a curse when the strategies become correlated, as they do particularly when something has gone wrong, and you have to sell.  These trading groups have become too big in comparison to the organizations they supposedly serve, and the advantage of being able to play with an almost infinite pool of shareholders’ money becomes a disadvantage, because it is too easy to become oversized compared to the market in a particular security;  being oversized in a basket of correlated ones (since they are all part of the same strategy) multiplies the correlation.

Dimon’s real mistake was in believing—or allowing others to convince him—that trading, or indeed any business activity, is infinitely scaleable, and that it is possible to hedge $340 billion in credit exposure and other banking activities the same way you can hedge $34 billion, or $3.4 billion.  Just as with the cartoon images of a human-shaped being 60 feet tall, it doesn’t work in reality; other things have to change, and drastically, if you are going to be that big.  It’s elementary physics.

Not only do risk managers have to become more knowledgeable and powerful, risk limits have to be respected.  Psychologically, traders are the worst people in the world to have to manage this risk, because, by definition, they are risk-seeking, rather than risk-averse.  And since the strategies are so complex, it is impossible for anyone, no matter how financially sophisticated, to understand more than a few of them, let alone every circumstance in which they might begin to correlate in unfavorable ways.  The general manager of a bank, who has to have many other duties and skills, only one of which is supervising trading departments, cannot possibly review all this work and stay on top of it.  The chief risk officer, who has many other areas to watch, cannot possibly monitor all the risks involved.  The trading departments of the modern mega-banks have simply become too big for anyone to understand sufficiently to control them.  And then there are the human variables:  the supervisor who was able to hold the line on risk exposure gets sick or has a family crisis and has to resign.  There is a hiatus. Her or his replacement does not know the situation as well, cannot command the same initial respect from subordinates, and does not have the same clout in the organization.  A key person is having emotional problems, or personal distractions.  No system is immune to breakdown.  And the bigger the system, the greater the effect of that breakdown, not in a linear fashion, but exponentially.

The only answers seem to be, either to drastically limit the size of any one bank, or to somehow regulate and limit the complexity of trading strategies.  The former may limit the ability of banks to fulfill the financial needs of their corporate customers.  (Although there are those who say that banks haven’t been really serious about corporate finance since the traders took over.)  The latter may be impractical, likely to discourage innovation or to drive it offshore. But both have to be considered, studied, seriously, honestly, and with as little bias as possible, and probably implemented to a greater or a lesser degree.

On thing seems certain:  one risky strategy cannot simply be offset by surrounding it with a plethora of competing strategies which in theory offset one another:  under extreme conditions, any two strategies can correlate, and then the only defense becomes the ability of the parent organization to withstand the loss.  As long as trading desks are able to finance their operations with a deep pool of someone else’s money, exaggerated risks will continue to be taken by some, and fail to be adequately controlled by others.  The only answer is that those who propose to undertake these risks must have their own personal wealth (and not just next year’s bonus) tied up in these strategies.

Years ago, Jamie Dimon himself very cleverly began a policy of putting everything his managers asked for into their budgets; not just the usual items, but also established perks and even incidentals.  If you wanted to have the Wall Street Journal or the Financial Times delivered to your desk every day, it had to come out of your budget or out of your salary. This made everyone stop and think about how badly they really needed some of these perks and services.  Perhaps this was going a bit too far:  some who might be instinctively cheap possibly deprived themselves of information that could have made them more useful and productive.  But it certainly took a lot of fat out of the cost structure!  For most, the intellectual exercise of the trade-offs entailed by having to adhere to a budget is useful.  Those for whom it is counter-productive and who deprive themselves of necessary expenditures for the sheer virtue of saving money at any cost, will see their productivity fall, and if the situation is serious, will soon be out the door.

Those senior traders and their chiefs charged with implementing novel and cash-consumptive trading strategies should have to make the same trade-offs.  If this means that many trading operations have to revert to being partnerships of one form or another, so be it.  There is presently too much risk in the system:  too much for shareholders, too much for the stability of markets, too much for the safety of the whole economy.  If J.P. Morgan can screw up, everyone can; but not everyone can afford to take the hit, especially at times when there is other turbulence in the markets.

Why is this a governance issue?  Because it is up to boards to say, “No more.”  And it is up to boards to appoint CEOs who are unlikely to bet the farm, again and again, until one day it is gone.  And if their ambition is to make it the only “farm” on Earth, it will go:  the sheer scale of it simply won’t work.  We’re seeing that already.

—From the so-called “Laws of Perversity,” corollaries of Murphy’s Law:  ‘If something can go wrong, it will.’

If the reports of investigative journalists prove to be true, Wal-Mart has been pursuing a policy of “See no evil, hear no evil, speak no evil,” with respect to criminal corporate misbehavior in its Mexican subsidiary.  As a result, the company is now in big trouble, (and its share price has taken a big dive), because of  substantial bribes being paid to facilitate operations in Mexico which senior management first ignored, then attempted to cover up.  This is a classic example of why improved governance structures are needed at successful companies, and not only at those which have experienced problems in the recent past. As usual, investors were inclined to cut the company an enormous amount of slack because it had been so successful and apparently well-run.

But corporate governance is mostly about ways to diminish the risk of something going wrong, not about methods to make the day-to-day functioning of a successful company even more efficient and profitable. Here, an essential mechanism—whistle-blowing, and the proper procedures for conducting allegations of corporate misbehavior—was neglected because everyone trusted management to continue to grow the company, and ignored the possibility that some trusted manager would abuse his position, or cut corners. And now shareholders have taken a huge hit. Nor, in all likelihood, have we seen the end of the problem.

In a way, it’s like speed limits: no reasonable observer should doubt that most of the time it is perfectly safe for the alert driver of a modern, high-quality car to go far faster on our public roads than the posted limits. The problem comes when the driver is distracted, or there is something wrong with his car, or with road conditions, or most frequently when there is some unexpected external event:  a child dashing out into the road, a stalled vehicle around a bend, an oncoming car which has lost control. Then, suddenly, the magnitude of the mishap is enormously magnified, and a major calamity is more likely to occur. It is to make such calamities less likely that companies should have all those tedious, “unnecessary,” and mind-numbing procedures dictated by the canons of corporate governance best practice:  ombudsmen, whistle-blower protections, rigorous internal investigation procedures, use of external investigators when it appears necessary, and the willingness to discipline executives who violate the trust of shareholders.

Reliance on ad hoc procedures has so far cost shareholders $15 bn, and we are nowhere near finished with the fallout from this scandal.

While there was a lot of piling on by those who agreed with his dim view either of Goldman in particular or of investment banking in general, and an ample amount of Schadenfreude from those who did not work in the sector, there were many who either jumped to the defense of the firm, or who essentially met the accusations of the employee, by arguing that investment banks had always been that way, and always would be, because that was the nature of financial markets businesses.  In essence, they were saying that all dealings with investment banks are conducted at arms’ length by knowledgeable individuals who are trying to take advantage of each other, that no securities firm has any obligations to its customers other than to deliver whatever securities are agreed upon at the negotiated price, and that caveat emptor has always been and should always be the law of the financial marketplace.

This last argument is wrong, and dangerously cynical for two reasons:  it assumes that all financial services businesses are akin to open-market trading, and it assumes that every participant in those markets knows as much as every other, or at least, ought to.  On the contrary, the investment banking business is extremely diverse and includes many activities which are nothing at all like the horse-trading of listed securities for a short-term gain, and the survival of effective markets depends upon both the efficient bridging of asymmetries of knowledge and the maintenance of specialists who can serve as sources of knowledge and providers of services which depend upon that specialization.  The problem is that all of these services have been brought together under one roof because of the economic advantages of size and access to low-cost capital, and because too many participants in the industry labor under the notion that they are not only smarter, but more knowledgeable than anyone else in the room.

The existence of such highly-paid middlemen as investment bankers suggests that they serve some purpose.   It was of course possible, so long as the stock exchanges had a monopoly on transactions and could limit memberships, while at the same time having the power to expel anyone who engaged in price competition, for stockbrokers—as well as anyone whose business dealings would ultimately involve a stock or bond market transaction—for these middlemen to extract rents.  But that cozy arrangement crumbled years ago:  by 1985 it was substantially gone in the United States, and one year later, it was voluntarily disbanded in the UK, and shortly thereafter, in France and other countries with developed capital markets.  Moreover, a tremendous amount of capital went searching for returns by investing in the intermediaries those same capital markets.  Interestingly, despite so much money chasing returns in the same place, while (as would be expected) it drove margins in traditional activities almost to the vanishing point, it did not decrease the industry’s profitability, and especially not for the employees paid by those same investors who had ended the old markets’ cozy cartel.  That should suggest that, somehow, they were able to add value.

This was despite the fact that more and more studies kept coming out which demonstrated that it was difficult, if not impossible, for anyone to beat the market consistently, especially on a short-term basis, which would suggest that the advice and informational advantages supposedly enjoyed by financial intermediaries were of little value.  Moreover, many of the clients of the financial intermediaries were also under severe financial pressure, while others (corporate clients in a stock market and economic boom) were of such relative financial strength that they were able to put pressure on the investment banks’ margins anyway.  But—despite many ups and downs for their owners—the banks and bankers were able to claim an increasing proportion of overall profits in the economy.  Either the new combinations of all the formerly separated financial businesses were incredibly powerful, or thanks to the synergies now inherent in financial services, their rapidly rising numbers of employees were increasingly valuable, or both.  Certainly, the exponentially rising incomes of so many employed on the Street, in the City, and in their counterparts elsewhere in the world, would seem to require that one way or another, employees were adding value.

As middlemen, brokers, corporate financing specialists, and traders have always enjoyed being at the center of a nexus of information unavailable to other participants in the financial markets.  The new, universal investment banks exploited this position to the hilt, and in an increasingly complex and interrelated financial system, despite increasing transparency, and the development of new and increasingly democratic means of exchanging information, the informational asymmetries remained and even grew.  Thus, it was worthwhile for users of the financial system to continue to pay for the services of bankers, and it was worthwhile for the owners of banks to pay for the employees which made the system go.  The problem is that the shortest cut to the greatest profitability was to exploit the asymmetries to the principal or sole benefit of the bank itself.  And this was new:  before, it was the long-term relationship with the well-financed client which was the basis of making money on Wall Street:  the bank took a steady cut of the cash flow, which had to continue if the bank would remain profitable.  But now, it has become more profitable for the firm to compete with its own customers.

As one reader in the Financial Times aptly put it, the defenders of Goldman (and critics of Mr. Smith as being hopelessly naive) assumed that the patient should know as much about medicine as his physician, understand automobiles as well as any mechanic, and know as much about plumbing as the plumber he calls in to fix broken pipes or a leaking toilet.  Leaving the first example aside perhaps, because it involves one of the learned professions, and a whole host of professional certifications no layman can be expected to have, the reader had a very good point:  we all have every reason to expect a certain duty of care whenever we deal with any specialized business we pay to supply a particular service.  This is the whole point of having a non-subsistence economy with divisions of labor.  This is why licenses are required for so many service businesses, stockbroking among them.  Far from being typical, trading is actually an outlier in the financial services industry.

Portfolio managers, for example, may believe themselves to be exceptionally well-informed, wired into all sorts of information networks, and financially sophisticated.  But they cannot and should not know what their competitors in the marketplace are doing and saying at any particular moment, because they are not in a central position, but on the periphery, and because they are competitors.  If an institutional salesman whom they know and have been dealing with, from an established firm, calls them and tells them that a particular security is behaving in a particular way, or that his customers seem to be adjusting their preferences with regard to securities selection or attitudes toward risk, this information may or may not add value, but it should not be deliberately deceptive.  The same is even more true for an initial offering of a new security, where the law has imposed various rules about what must be disclosed, and various other rules about how any non-factual information (e.g., forecasts and projections) must be presented.  The portfolio manager would be a fool to take whatever they are being told as gospel, and not to check on the information given, to make sure that it is in accord with or at least does not contradict something they know to be true, and to be aware at all times that there will normally be a bias in favor of action in whatever the salesman is recommending.  But the portfolio manager also knows that the salesman has access to information which the PM does not, and that without such sources of information, they are flying blind with respect to the marketplace.  Similarly, the corporate financial officer needs to know about the market conditions into which their company may be contemplating issuing new securities, buying back their existing ones, or considering the purchase of another company.  Some of this information can and should be verified using internal personnel doing their own research and collecting their own data, but it would be absurdly inefficient and prohibitively expensive for every investor and every issuer to have a complete investment bank in-house, and such an operation still would not be able to replicate the information flow available to a market middleman dealing with hundreds of market participants every day.

The situation is exacerbated in the case of financial innovations, which have been appearing at an ever-increasing rate, despite the fact that many of them have been discovered to have hidden flaws not apparent when they were first employed.  The PM, or the CFO may actually be as smart as they think they are, and they still should have no reason to be expected to fully understand every complex new financial device or strategy being marketed to them.  One alternative is for the prospective customer to refuse to deal in anything which is not old and familiar, and there is much to be said for such conservatism, but there are also opportunity costs attached to such an approach, and the pace of change in markets may leave those restricting themselves to such a strategy in the position of losing clients, as well as opportunities.  So, like it or not, the investor and the issuer alike must deal with the investment bank at less than an arm’s length, and this implies that a certain amount of bona fides is demanded of the bank as well.

For many years, some firms had an interest in being more ethical than the rest, because of the exceptional value of their franchises—like the old “bulge bracket” underwriters—or because of their reputation as advisors, either to corporate clients or to investors.  The quality of the client list was all-important, and the key to the individual banker’s value at that time was his share of the relationships he brought to the firm.  Wire houses—which depended upon a retail clientele spread around the country—and trading firms did not enjoy the luxury of such long-term and usually exclusive relationships.  Goldman Sachs was a relative newcomer to these elites (there had been some murky and embarrassing scandals in the 1920s, even by the gamy standards of that time), but through the boom years of the 1950s and 1960s, the firm’s franchise improved, it survived the stressful years of the 1970s with its reputation intact, and by the 1980s, Goldman was part of the “bulge bracket” itself.  Some firms successful in those years became known for being hungrier, and some for exploiting their broad distributional base to buy their place at the table, but Goldman managed to expand its franchise by being known as both smarter, and to a large extent, more ethical than the other newcomers.  For example, in the increasingly brutal field of m&a, the firm made much of its reputation for mounting successful defenses of companies under attack, and therefore refused to act on behalf of a hostile acquirer.

As trading-oriented firms, such as Salomon Brothers, with their bruising culture of blatant self-interest, increasingly began to dominate the industry, Goldman kept its bankers in the forefront, its traders in the background.  When the other firms went public and sometimes sold themselves three or four times over to ever-richer bidders, Goldman remained independent, and a partnership.  They fostered an image of cruising above the fray, because they were better, smarter, and therefore could afford to be more ethical.  But the banking business was becoming ever-more deal-driven, and client loyalty had become a thing of the past.  A critical moment was reached when Goldman decided to stop turning down would-be hostile bidders, and another was reached when traders began to be promoted to senior managerial posts.  Finally, the firm ceased to be a partnership at all, but sold itself to the public, removing the last barrier to any sort of common internal interest—all of its competitors had of course long since taken the same path.  Henceforth, Goldman traders and other risk takers would be playing with shareholders’ money, rather than their own.

As Goldman expanded its business model, and became increasingly involved in various aspects of the financial markets as a principal, rather than as an agent, the potential for conflicts grew, and often their reality as well.  Customers became more and more aware of the disconnect between the supposed Goldman ethos and the reality of personnel who were increasingly looking out for their own benefit entirely, and the customer’s almost not at all.  At the same time, Goldman became the most vigorous and visible defender of the status quo thanks to their unparalleled links to government, the fruit of former partners who had become key members of several Administrations, and the many ways they had shown of favoring their former firm.

Thus, the current model for investment banks, which is employed by almost all of them, is rife with conflicts of interest.  As the defenders of the industry point out, some of these would be inherent in any model of the financial services industry, and indeed have always been with us, but in the past these tended to be self-limiting:  rent extractors who were too ruthless began to lose customers, and actual fraud was eventually punished.  Many of the conflicts of interest which are so profitable today, however, are specifically a byproduct of the broad spectrum of services these banks offer, which include proprietary trading, private equity investment, fund management, institutional and private client brokerage, primary broking for hedge funds, m&a, and underwriting.  Not all of these businesses can cohabit without there being serious and potentially insoluble conflicts. Until and unless banks decide what business they are in, and whether they are going to be acting primarily in the interest of the client or primarily in opposition to it, these stories will continue, and cynicism will only grow, within and outside these firms.

Goldman is now getting clobbered in the court of public opinion not because they are uniquely conflicted but because they are (a) the most successful firm on the street, (b) have attained enormous political influence, and (c) have been one of the most hypocritical about denying the possibility that such conflicts exist.  They will continue to be subject to such bad publicity until and unless they choose—as they were once forced to in the past—to emphasize either their advisory and agency businesses, or their proprietary ones.  Perhaps the lure of profits will continue to triumph over the desire to have a good reputation.  But the danger, aside from the risk that business begins to flow to other firms using other business models, is that public outcry will continue to rise, that Goldman’s political links will ultimately prove unable to counteract the pressure, and that regulation and legislation will reduce or destroy the profitable model the existing investment banks are using.  Worse, there is the risk to the public that financial markets may be crippled in their functioning through such a punitive and retributive process.

The problem, as Professor Bainbridge should know, is that we are dealing with two very different kinds of legislation here, with different intent.  One is intended to substitute government agencies’ control for the decisions of independent actors (managements and the free market.)  The other is intended to ensure that the free market, i.e., the shareholders, have the power to do something regarding their own investment—other than sell it—when they feel that it is being mismanaged.  The dichotomy is important:  regulatory decision-making by government agencies, vs. the actions of independent economic actors who have invested their own money with the company.

“Corporate governance” is frequently used as a synonym for some sort of reform.  This is misleading.  Every corporation must be governed.  The questions are How?  By whom? and, Well or badly?  The question for legislators and the markets is to what extent the corporation (which is, let us not forget, an artificial creation of the State) is allowed to run itself without external interference, and to what extent outsiders are allowed to intervene.  Clearly, when the company violates some other laws pertaining to the public good (i.e., pollution, sale of defective merchandise, abuse of its labor force and/or of public safety, fraud) the State is entitled to intervene, just as it would be if the actor were a private individual.  But that is not the issue here.  The issue is the internal governance of the corporation.

If the managers of the company are the principal owners, there is no agency problem:  it is their money, and they are allowed to do with it what they want, (providing they do not violate any of the laws regulating external behavior, as above.)  Normally, they will be very careful with their own property, and ‘monitoring’ is seldom a problem. The issues instead involve fair treatment of minority investors, who own less than enough to control the company, even if they were to vote unanimously.  Their protection necessarily involves market regulations, listing rules, and laws to make sure that they receive their fair share of any distributions (dividends or asset sales), and are not victimized by self-dealing among the dominant shareholders for their own benefit, looting of the assets, etc., because market responses would have no effect upon the situation.  The potential for such issues becoming problematic frequently arises among smaller corporations, and more often among some larger ones in other countries, particularly those with less-highly developed capital markets.  But the more commonly-expressed concerns regarding corporate governance do not apply.  Most entrepreneurial enterprises also fall in this category:  the founder has his or her own wealth at risk, and any significant investors they have usually know management personally and are frequently represented on the board.

The problem arises—and it is particularly acute in the most developed markets, the U.S. and the U.K. most notably—where the company is mature, ownership is widely dispersed, and management has only a relatively small stake in the capital.  The company is essentially ‘ownerless’ (as one prominent authority has described it) and it is run by whomever has control of the executive suite.  Absent some sort of check on the part of the shareholders, the managers can do whatever they want, for the good or ill of the corporation, and no outsider has any effective say in how the assets are being used.  Particularly if management is entrenched through the use of anti-takeover devices, even the extreme case of relying upon the discipline of the market is of no avail, because the market for corporate control does not function.  There have been repeated cases where such managements have been able to loot the company, leaving only a shell for their shareholders, without violating any laws.  Enron was a prime example, but there have been many others.

Fortunately, only a small percentage of  managements have any such larcenous intentions.  However, it is much easier for managers and directors to confuse their own interests with those of the company:  this is a nearly universal human tendency.  Lavish payouts to the CEO and other senior executives, who may have done their jobs well—but can be morale-crushing in times of distress and economic contraction of the company, dubious strategies which benefit certain insiders at the expense of the rest of the corporation, radically raising the risk profile of a company when it is, after all, someone else’s money at risk, and not their own—these are all problems which are dealt with only imprecisely and clumsily through regulation, with frequent unintended consequences, but which can and should be subject to review by those whose money is actually involved:  the shareholders of the corporation.

All that is required to allow this mechanism to function is that the laws and regulations involving the existence and functioning of corporations be properly written so that those with the capital—most of them institutions representing small savers who are relying upon their investments to make a comfortable retirement possible—be allowed to express their concern and possible disapproval by removing some or all of the directors if necessary.  In most ways, this is the ANTITHESIS OF REGULATION.  It does not involve a government agency telling a company what it should do, what strategies and practices it may or may not follow.  It is simply guaranteeing that the free market can function properly, without insiders managing to tilt the playing field so that they have an insuperable advantage.  It is ensuring that those with capital at risk potentially have some say in how that capital is employed.  Of course, the investors can decline to do anything with this power.  Most of the time, they will do nothing, and probably should do nothing.  But it prevents egregious abuses, and more importantly, it encourages the managements of companies with dispersed ownership to communicate more clearly with those whose money is at risk, to make sure that they are content with what management is doing in their behalf.

Opponents of this sort of governance reform deliberately confuse matters by conflating it with hyper-regulation and micro-management by government agencies.  Lobbyists on behalf of managers and boards who wish to do whatever they want (especially to extract oversized compensation packages from companies essentially for functioning as bureaucrats overseeing well-established companies) have successfully confused the issue so that their clients may continue to exercise control over assets which are not their own.  This is not entrepreneurialism, it is the modern version of the same game of monopoly which has been played since the days of the first exclusive royal charters in the seventeenth century.

Similarly, “activists” are not all cut from the same cloth.  Some are busybodies who labor under the mistaken belief that the corporation should function like a popular democracy, with all significant decisions of the board subject to micro-management through mandatory shareholder approval.  These are actually rather rare.  Some are single-issue advocates, who attempt to impose their special views upon a corporation resistant to their ideas.  Some are attempting to hijack the corporation to shift its balance of decision-making in favor of some specific constituency.  One thing all these have in common is that they are unlikely to find support among even a significant minority of shareholders of any reasonably well-run corporation.  Another group of activists are those attempting to force a transaction—sale of the company, a merger, an acquisition—to their own advantage.  Such activity will only succeed in attaining support of a majority of shareholders if it is in all their interests, and management cannot make a case why they shouldn’t do it, in which case, it probably should succeed.

Finally, there are those activists—frequently the most reviled by managements, because they are the most difficult to buy off with token measures or compromises—in favor of good governance in general.  These attempt to foster adoption of those mechanisms which can ensure that the company listen to its shareholders when it is important for them to do so, and to abolish those measures which tend to entrench a management, or allow abuses to proliferate to the detriment of the majority of shareholders.  This last group of activists, which includes most of the governance activity engaged in by the better-known pension funds and other institutional investors (including some hedge funds and certain private equity funds) is wrongly lumped together with the others. Unlike them, it is neither event-driven nor directed myopically at some single-issue cause, nor is it dedicated to promoting some self-interested subgroup at the expense of the other shareholders.  Almost all of these are geared toward improving the rules by which the company is run, making the corporation a better long-term investment for its shareholders, and keeping it functioning in conformity with the objectives and risk profile the investors assumed when they bought shares in the company, until and unless there is a consensus that these should change.  And let us not forget, the measures these activists advocate will succeed only to the extent they are perceived by the majority of shareholders as being in their own interests, and voted upon accordingly.

Confusing this investor-friendly approach to corporate governance involvement with increased governmental regulation is unjustified.  In fact, most of the proponents of better governance advocate decreased regulation, provided that the shareholders, and therefore the market, get to pass on major departures from good governance.  This is at the core of the ‘comply or explain’ approach taken by so many corporate governance codes of best practice around the world, and by the most influential advocates for improved governance.  Yet this conflation of two different causes has successfully hijacked much of the Republican Party’s thinking, on the grounds that it violates their ideology that ‘less regulation is needed in order to free up the entrepreneurial energies of our free market system,’ when what is being protected here is neither entrepreneurial nor the exercise of free markets.  Normally, Republicans would be counted upon to defend the interests of private property, but here most oppose it, as if it were the managers whose property the company was, rather than the shareholders.

Conflation of the two opposing approaches has also had the perverse effect of benefiting special corporate interests at the expense of the small investor and saver/would-be pensioner by confusing the Democratic Party on ideological grounds as well:  the party which ostensibly believes that government must intervene directly wherever there are abuses of power by entrenched interests, ends up forever adding on further layers of regulation which are always to be administered by the same incumbent management.  Most of these are enacted in lieu of any reform of the fundamental method by which companies are controlled and managements are chosen in the first place.

The two must be separated, once and for all, or we will end up with the worst of both worlds:  a private sector hopelessly encumbered by regulations, most of which do not accomplish their intended purpose but which add immeasurably to the uncompetitiveness of the economy, while the free market continues not to function at what it is supposed to do, allocating capital to those enterprises which can use it best, and away from those which are wasting and destroying it.

We have excessive volatility because it is the interest of trading firms to encourage it, that’s why. And since all of today’s banks have huge trading operations, which generate a large share of their profits in good years, whenever they talk to clients or to the news media, they all encourage volatility. With low volatility, they would soon be out of a job. And before that, their bonuses would evaporate. Again, the question must be asked, is all this volatility helping or hurting the fundamental function of markets (which, contrary to widely held belief, is NOT to make a relatively few traders rich)? If the volatility is harmless—hey, why not? But if it is harmful, if it makes it more difficult for the economy to expand because economic producers cannot raise capital in the markets at fair prices, or savers are afraid to commit their money to economically productive enterprises because of the terrifying lurches in the market, then it should be curbed.

One can argue that the markets ought to be volatile due to the uncertainties of the present economic situation. But the present economic situation has been pretty static for quite a while: there is news flow, but no real change in the outlook, which remains somewhere between very sluggish growth and a modest (but discouraging) further contraction. What real news should induce investors to be 3% more optimistic one day, and 4% less optimistic the next?  The largest part of the market volume is algorithmically driven (HFT alone is  56% according to TABB, an association of quantitative traders, and this does not include the huge volume in other quant strategies involving ETFs and other non-economic market correlations); there are no fundamental convictions involved, nor any view of the markets lasting beyond tomorrow. So what useful function is all this volume serving aside from providing an income to traders? Worse, since many of these quant strategies are zero-sum games, there is no net gain to the economy.

Has anyone done any comprehensive studies of whether all these new forms of trading add to or subtract from the original function of markets? I haven’t seen one; academics just assume that liquidity equals efficiency. Nor have they ever conceded that markets can be hyper-efficient (i.e., over-react), which anyone who has ever been a portfolio manager knows to be a common phenomenon. And everyone loves to forget the great market crash of 1987, which presaged nothing, and where most of the liquidity was provided by computers trying to sell enough options to make up for the gaps down in share prices. (They never could catch up. If the market had been open another hour, it probably would have fallen another 20%.) This form of portfolio insurance is now remembered as a ‘success’ by its academic inventors, but it was a dismal failure for anyone who put any money into it.

One would know none of this from reading the public statements of senior bankers against restrictions on their proprietary trading or any other fundamental changes in the structure of our capital markets. In response to ex-Fed Chairman Volcker’s call for ring-fencing and reduction of these activities, the Administration has been waffling, while the bankers say, ‘Over our dead bodies.’  Many of these same bankers were members of the blue-ribbon Council on Jobs and Competitiveness which recently called for severe curbs on Sarbanes-Oxley’s auditing requirements, and which received President Obama’s unqualified endorsement; this despite the horrendous accounting scandals we have had which defrauded millions of investors of billions of dollars, and precipitated at least one major market decline, as well as making the Great Crash of 2008 possible.  How likely is reform of our markets when both major parties seem to share this Panglossian view that we have the best of all possible capital markets in this best of all possible financial worlds?

I’m afraid that most of this discussion loses sight of the real issues. Liquidity is not an end in itself. Cheap execution is not an end in itself. And I’m afraid that huge bonuses are not the goal of capital markets, either, although they are wonderful to bring home for the trader him/herself. In fact, much of the money made from trading is merely a form of rent extraction, which means it is raising costs for everyone else, there is no net gain, and probably a net loss.

Capital markets exist to bring together natural lenders of money with those providers of goods and services who by their very nature have a constant need for capital. All the rest of our market activity is derivative of this basic function. Savers (investors) have long believed that they can get an excess return on their investments if they invest their money intelligently, and this has given birth to a huge industry in search of these excess returns. Unfortunately, not every technique works consistently, and none works over every time period, so there is a constant search for new techniques. It is in the interest of the general economy that markets allocate money to those investment opportunities which will lead to the greatest amount of net economic gain for their owners, and therefore the highest returns for investors. This is the real meaning of efficiency.

Quantitative techniques are a way of gaming the system so that one tries to get a positive return no matter what is going on in the real world of the economy, by looking at correlative market events having little or nothing to do with the general economy. They are at best, a sideshow to the main event. Unfortunately, because such gains are inherently minuscule (if they exist at all) on any one transaction, they must be multiplied by vast volumes of trading, or by using huge amounts of leverage, to make them worth anyone’s while. This often leads to excess volatility, especially at times when the market lacks clear direction. If there are hidden risks, which were not properly accounted for in the trader’s algorithm, they can cause enormous losses, and perhaps even start panics.

There are always going to be people who are looking for a way to get a free lunch, including those who believe, despite all the principles of science, that there is such a thing as a perpetual motion machine, that it is possible to turn lead into gold, that one can find a chemical or physical reaction which results in a net gain of both mass and energy with no entropy loss, and that it is possible to make money on the stock market without doing one’s homework, and finding something truly undervalued. Historically, in the grand scheme of things, such people were relatively harmless—perhaps they defrauded a few investors, but that was all. Unfortunately, with the vast amounts of leverage now commanded by some traders through the magic of derivatives, this quest for the the gimmick that gives one a free lunch can become very expensive indeed.

Portfolio insurance was a fraud, which directly led to the market crash of 1987. Long-Term Capital Management had run out of gimmicks, so they started gambling on naked risk arbitrages with huge leverage, and caused a market panic in 1997. Collateralized Debt Obligations were a fraud which caused the great credit crisis of 2007, multiplied by the leverage offered by CDS, which accelerated the crisis. All of these quantitative strategies were supposed to make markets more efficient; in the end, they all led them astray. I think that regulators need to stop giving all arguments for increased liquidity a free pass. There is such a thing as excess liquidity, and just as seawater sloshing back and forth on the deck of a Roll-On-Roll-Off auto ferry caused it to sink, excess liquidity careening back and forth within markets causes frightening volatility, scares off investors and borrowers alike and can cause crashes. It needs to be brought back within rational limits.

That is when the real break occurred: Hurd essentially changed the culture of the company by trying to turn it from an engineering-driven hardware product innovator to a lower-cost follower of industry trends. When Hurd had to go, because of personal indiscretions, it seemed natural to the board to ignore corporate culture yet again, and bring in Apotheker, who tried to transform the company into a software house (not surprising given that he came from SAP, one of the leading software producers.) That, too, appears to have been a disaster.

The problem seems to be that this board acts as if they can move the pieces of the company around the board at will, like some sort of demented chess player who thinks he can exchange a bishop for a rook whenever he wishes, and occasionally add some additional squares to the board when he needs the extra room. In real life, you have to work with the material on hand, and changing a corporate culture is a slow and perilous business. Clichés like ‘think outside the box’ and ‘every company needs a radical infusion of fresh blood from time to time,’ are bandied about too casually in many boardrooms, especially by CEOs and ex-CEOs who may have an exaggerated impression of their own ability to exercise their will upon others.

Although we don’t of course know exactly what may have been going wrong inside, it also may not have have helped that the HP board seems to have become as impatient as the stock market. Shareholder-friendly corporate governance is one thing; running a company as if it were a marketing focus group is something else.

Me: Hijacked by whom, exactly? An obsession with board process can be as much of a distraction as one with shareholder ‘democracy,’ regulatory compliance, stakeholder interests or anything else. The point is that a company should be efficiently run, with optimal management of the risks it is running and/or is likely to encounter in the foreseeable future. What else is governance about?

—How about Responsibility, Accountability and Stakeholders Value Creation? Just a thought…

Responsibility—yes, but to whom? Accountability, absolutely—but for what? Stakeholders’ value, surely—but why? For being a good steward of the assets which have been entrusted to you: that you managed them well, and for the future as well as the present time. The three you cite are important, but I see them as means, not ends. Which is why I gave the above, admittedly reductionist formula. The company should be the best manager of the assets it controls (including the portion of people’s lives it affects), and it should attempt to continue to be so for the indefinite future. Since that includes shareholder value in the broadest sense, I don’t think it’s hijacking anything.

—Ends and Means…uuumm I like where this conversation is going. Since Governance is just a means to a end… what is the end?

Good stewardship: sustainable profits for the owners, reliable goods or services for customers, fair and beneficial relationships with the other stakeholders, good economic use of the assets. I think that covers it—no?

—I think you might have missed a bit… commonly known as natural resources, which I would rather call Natural Capital. I wonder though, if the end of Governance is Good Stewardship, what is the end of Business, its purpose?

Business? I would say ‘economic activity’ is the end of business. It’s very neutral, and completely amoral—a good business, a bad business, a criminal business, a profitable business, a tax shelter, a charitable business, etc. etc.

So the purpose of business is generating economic activity? in other words, everyone works just to keep themselves busy so that someone else gets richer? is that what you are saying? that would not make me want to get up in the morning, and certainly not inspire me to work.

In my view, economic activity, like governance, is still a means, not an end. Any other views or suggestions?

People engage in economic activity so that they themselves get richer! Or so that a non-profit can do whatever it does: stage artistic performances, aid the less fortunate, provide for education . . . Or for any of the many other purposes one can think of for a business. Yes, of course it is a means to an end. I didn’t think we were on this site to talk about the Meaning of Life, but if we are, personal benefit, broadly defined, would be part of the reason for human activity, altruism another, and if you believe in God (or any other transcendent principle), serving him (it) would be a third. Obviously, personal enrichment (this includes survival) heads the list where economic activity is concerned, because there the link is most direct.

I suppose what you are saying is, “Why should anyone in a position of power care about good governance, if the only results serve base ends or else accrue to someone else’s benefit?” but that shouldn’t be it. The point is that good governance makes higher returns (including non-economic returns and intangibles, if those are your goal), sustainable. That is, over time, the investments which are necessary to allow any business to function—money, human capital, natural resources, brand equity—will only flow to those businesses which adequately reward them over the appropriate time frame. So you shouldn’t manage the business only for next week, unless your stated goal is to make a quick return and pay off the stakeholders. This is, I think, the logic behind [another member's] point that the goals of governance are variable; they should be consonant with the expectations of those who have invested money, time, effort, and other scarce resources in them. If you are deluding or otherwise disappoint any of these stakeholders, they will sooner or later withdraw their stake, and refuse to support any more of your ventures.

The alternative to this model of governance is really: ‘There’s a sucker born every minute.’ That’s a form of fraud, and I think most of us would agree that it is both socially undesirable and unsustainable as a business model.

Dear Professor C_____:

In response to the question whether it is worthwhile to discuss stock lending practices in the context of a UK consultation regarding short-termism versus a long-term investment perspective, I would summarize the current state of lending activity as follows:

The biggest problem with stock lending in this context of short- vs. long-term perspectives is that it provides a powerful inducement not to vote on issues which are otherwise deemed important by the investor in question—either the asset manager or the beneficial owner.  This can produce conflicts between owners and managers, particularly when a major part of the managers’ business model is built around margins from lending, as it often is with index fund managers. Related issues are that it sometimes interferes with other  engagement activities, may on rare occasions threaten the integrity of the shareholders’ meeting, and that lending is not quite as risk-free as it has often been portrayed to trustees. But the real stumbling block from the viewpoint of the lender is the effect upon voting.

The ICGN Securities Lending Code, which addressed these issues from an international perspective, called for more transparency in lending activity.  In particular, lenders should (1) implement a clear policy regarding these potential conflicts between voting and lending, and make it public, particularly to beneficiaries, (2) that the income from lending be reported separately from investment income, and (3) that all parties to the lending process pledge not to lend shares in suspicious situations, when they have reason to believe that someone is borrowing shares in order to influence a vote.  This third point has been much ridiculed by the agents and custodians, but in fact there have been cases where loans suddenly went ‘special,’ (i.e. someone was suddenly willing to pay a significantly higher margin than usual) with unusual or rigid delivery terms, in the days just before the record date for a controversial vote.  Borrowing shares for the principal purpose of voting them is banned in the US by Reg. ‘T’ and frowned upon in many other markets, but it is not usually illegal, and is in any case difficult to police.  The lending industry operates on the basis of ‘see no evil, hear no evil,’ and this may sometimes be an inducement to overlook the obvious.

In general, our attitude in drafting the Code was that lending is a useful activity which improves market liquidity, but that the tail shouldn’t be allowed to wag the dog. In and of itself, we see nothing wrong with some market participants profiting from a decline in a share’s price:  it is a part of price discovery.  Also, many loans have nothing to do with constructing short positions, but are rather for covering fails and the like, or for creating hybrid hedged positions in which the ultimate borrower may also be net neutral, or even net long.  And although the most frequent function is indeed to construct a short position, often the bet doesn’t work or has only limited effect, and the lender has lost nothing on the capital side either.  But this isn’t always true, of course, and sometimes the short sale might add to the weight of selling putting downward pressure on the share price.

With reference to the UK consultation:  One good thing about the UK which we don’t enjoy in the US or Canada is that the agenda is posted long before the record/reconciliation date, and therefore, investors have an opportunity to recall shares after seeing whether there is anything to be voted upon they actually care about.  One problem however, in the UK, which is not usually a problem over here is that there is normally a totally separate chain of authority for authorizing and transmitting voting instructions from that of portfolio management, including decisions whether a particular vote affects shareholder interests.  The right hand is not normally allowed to know what the left hand is doing. This could be addressed by re-writing the contracts to allow for direct communication between managers and custodians, but to the best of my knowledge, no one has done so.

A problem on both sides of the Atlantic is that lending is more and more being done by third parties, many of whom have authority to lend shares without informing the beneficial owner of specific loans.  Thus, a beneficial owner often gives out orders to vote its shares, not knowing that the majority of them have been lent, and may not be able to be recalled in time.  The procedures involved in the process could use updating, but those most involved are most resistant to any changes in the system, or any further investment in technology.

Since the margins on most loans are very thin, and the construction of short positions by prime brokers is very lucrative, it could be argued that the lenders are throwing away their votes for too little. For this reason, a few asset owners have withdrawn from lending entirely, as not being worth the cost.  But there are many others willing to step into the breach.

A danger particularly of the U.S. system is that lenders always have the temptation to augment their returns by reinvesting the collateral in riskier paper.  This was highlighted by the problems some pension funds had in 2008, when they discovered that their agents had reinvested the collateral from loans in risky and less liquid instruments, and then had to return the collateral on short notice without being able to cash the investments they had made, or only at large losses. Several public pension funds in the U.S. had put some of their collateral into SIVs!  So the riskiness of the portfolio was actually increasing, relative to the equity position.

Another problem to emerge in 2008 was counterparty risk.  Since a loan is essentially a contractual, unsecured agreement with a prime broker (the collateral is posted by the actual borrower, the prime broker acting as its agent),  there is some risk that if the counterparty goes belly up during a loan, part of the transaction may be tied up in bankruptcy proceedings.  In the US this risk has apparently been dealt with by changes in the law to explicitly protect such agreements, but to the best of my knowledge, in the UK it has not.  There were instances of lenders who had ‘their’ shares (i.e., the commitment to buy them back in) frozen for some months after the Lehman bankruptcy, but who still had to return the collateral.

In answer to your students’ question, yes, individual portfolio managers often want to know whether someone is betting against their long positions, especially when these are in mid- or small-cap stocks which may be more easily influenced by a few big shorts.  They sometimes ask to recall, when they know that such shares are being borrowed against their own positions.  However, if the lending institution is on average a long-term holder, they are usually told by their senior managers or trustees that the income is significant, and that over the longer term, the effect on prices is not significant.  They are also told that the process is a ‘riskless’ source of cash income (nothing is riskless, but never mind) and that they should shut up.  The greatest conflict, in my opinion, is not between asset owners and asset managers, but between those (senior managers, directors, trustees, and of course anyone in the lending apparatus) who have an interest in maximizing annual income, and those (portfolio managers, corporate governance staffers, and concerned beneficiaries) who are concerned about the capital return, either directly (the PMs) or indirectly over the long-term (governance types).

Feedback from the other parts of an asset owner or manager would usually act to mitigate some of these problems.  But lending is usually treated separately as a back-office function, and flies beneath the radar of most decision-makers.  Those administering the lending are (a) usually not involved economically with any other part of the investment process, and (b) always rely upon the argument that even a relatively piddling amount is worth vastly more than a ‘worthless’ vote.  Asset owners and especially their trustees have to decide beforehand whether votes (other than on sale of the company) are worth anything to them, and instruct their lenders accordingly.  Most don’t.

I don’t necessarily want to stir up a controversy between active UK lenders and governance advocates, but the share-lenders’ lobby has been very aggressive, and includes several asset owners which otherwise bill themselves as proponents of good governance.  I think many such funds have failed to integrate the issues with potential conflicts to governance policy because internal advocates of lending grossly understate some of the problems.  Indeed, the difficulty with ameliorating many mechanical difficulties which could be solved without suspending most lending activity is because the position of lending advocates is that there should be no encumbrance upon lending at all.

Incidentally, although it won’t provide lenders with substitute income, there is developing an alternative to the stock loan:  the single-stock future, especially when incorporated into an Exchange for Physical contract.  It’s cheaper, simpler, and doesn’t require anyone to borrow stock.  (Disclosure:  I am an independent director of OneChicago, the single-stock futures exchange.)

I look forward to discussing the subject further with you, if you are interested.

Best regards,

Andrew

Many things have been declared ‘dead,’ based on recent experience.  For example, political conservatism in the U.S. was declared dead by the media and most commentators only two years ago; four years before that, liberalism was likewise ‘dead.’  In Europe, socialism was ‘dead’ in 1991; British-style liberal economics in 1997.  The best one can safely say, at least until the dusty coating of history has covered something to a reasonable depth, is that it seems to be ‘moribund.’

Before one declares something called corporate governance potentially in need of a priest to perform the Last Rites, one should define it carefully.  The Cadbury Report defined corporate governance as “the system by which corporations are directed and controlled,” a definition which is frequently employed by other authors.   I haven’t noticed the corporate mode of organization on the wane in our society, and I assume that most if not all of these entities are both directed and controlled, (although occasionally a specific situation gives one pause.)  Companies will continue to need advice in all related areas.  Clearly, the article on the death of corporate governance must be referring to something far more specific.

If the author means to say specifically that shareholder activism motivated by concerns about corporate governance is dead, one must assume either:  that the concerns which once motivated shareholders have been forever remediated, or that these concerns are no longer of interest to shareholders, and are unlikely ever to be of interest again.  I would submit that the first assumption is extremely unlikely, given that no one has succeeded in changing human nature in at least the 5,000 years of recorded history.  The second, if true, is only true so long as the the concerns underlying the first  remain in abeyance and/or fully discounted in share prices.

While there is some evidence, at least in the U.S. and the U.K., that these elements have been fairly well discounted over the past nine years, there is no reason to believe that this is the case because either (a) investors have become permanently more rational, or (b) managers and directors have become permanently less self-interested.  On the contrary, it has been demonstrated that the reason governance issues or the lack of same seem to have been discounted in share prices is because investors became expected to pay attention to them, due to the excess returns gained from paying attention to these issues during the preceding 15 years.  This was thanks to the efforts of corporate governance activists, of proxy advisors, and the occasional muckraking financial news item.  If governance activism is in fact temporarily moribund, then after a while investors will cease paying attention to it, just as at regular intervals they cease paying attention to book value, return on invested capital, or, in bear markets, growth potential.  This means that there would again be an excess return to be made from paying closer attention to these same governance issues:  board independence, transparency, protection from rent extraction, and fair treatment of minority shareholders.

It seems that what the author is decrying instead is the loss of missionary enthusiasm among the first generation of activists, and the decline of a rational link between the governance concerns of investors and the proper management of a business.  It is indeed arguable that the present governance ‘industry’ is a victim of its own successes:   there is increased emphasis upon compliance with increasingly minor infractions, the area has become bureaucratic and legalistic, divorced from investment concerns, exploited by some for purposes entirely contrary to the original intentions attending its foundation, and the whole subject has become overlaid with layers of complex regulation, particularly in the U.S.

However, the U.S. is not the whole world, the new regulations will not cover all possible attempts to circumvent them, the majority of the largest corporations are not the whole of all investible propositions, and investors may be counted upon to ignore or eventually forget all lessons not recently acquired from personal pain.  Corporate governance watchdogs will continue to be needed the same way that police will always be needed; because some individuals will try to cut corners no matter what the environment, and many more will begin to ignore or even participate in whatever is going on whenever it seems that is what most of their contemporaries are doing.

As Prof. Frentrop has demonstrated, governance activism goes back to the first corporation, the Dutch East India Company, and began as early as 1609.  It will be needed in some form as long as some people manage assets on behalf of others.