Time to rethink primacy of shareholder interests

THE Libor case, in which Barclays has been accused of manipulating the London Interbank Offered Rate from as far back as 2005, potentially further erodes the rapidly diminishing public trust in banking and bankers.

It also provides another unfortunate occasion to question the fundamentals of the marketplace — in particular, shareholder primacy.

But why is this Libor case such a big deal? And why should we be concerned here in Australia?

Libor acts as an indicator of the health of the big banks; it is the estimated average interest rate banks use to borrow from each other, and is used to determine the cost of borrowing for a raft of financial products, including mortgages and credit cards. It also acts as a barometer for overall lending conditions, influencing interest rates around the world.

As Warren Buffett commented last week, when you talk about Libor: “You’re talking about the whole world.” Given the banks’ use of Libor and the potential impact on the economy globally, it’s time to question the banking industry’s singular focus on shareholder returns.

Of course, Australia is not in such bad shape as it has resisted the softer regulatory touch in favour of tighter prudential regulation and enforcement. However, as we have already seen, many Australians who have invested in certain financial products have been affected by the fixing of Libor. The Libor is set by 16 banks; at least 12 of these banks are being investigated in Europe, the US and Japan. This means that, potentially, numerous individuals and teams had knowledge of the attempts to fix Libor.

The Libor fixing casts doubt (as has happened several times since the GFC) on the integrity of banks’ control systems, risk management and codes of conduct. It shares the same characteristics as other events of this kind: it allegedly occurred over a long period of time; was not a one-off; rang warning bells and involved many participants from different institutions.

So we cannot blame just one rotten apple (as the Financial Times editorial opined when the issue first arose, “This is not a case of a single rotten apple in an otherwise healthy orchard”).

Finance scandals, such as the alleged potential $9 billion loss at JPMorgan Chase and the billions of dollars of money transfers allegedly linked to drug cartels at HSBC, continue to give rise to serious discussions about regulation, corporate culture, internal controls, economic conditions, and the leadership of those entities that have been exposed.

Something that is getting more attention is the fundamental purpose of corporations, and financial corporations in particular.

For whose benefit should the corporation be run and for what purpose? Given the crucial role banks play in the health of the global economy, we should question the prevailing ideology.

Shareholder primacy, that is, the idea that maximising shareholder wealth is the overriding objective of corporate activity, remains unquestioned in the mainstream debate on the role of financial institutions. Shareholder primacy is straight and simple: companies have one master: the shareholder, and one objective: to maximise wealth for that shareholder.

But the validity of this ideology and its consequences require our attention now more than ever.

One positive development in questioning this ideology has been the increasing emphasis on governance codes and principles.

There is also an increasing focus on the interests of other stakeholders, as exemplified by Australia’s ASX Corporate Governance Council, which aims to “optimise corporate performance and accountability in the interests of shareholders and the broader economy”.

In Australia, directors are legally required to act in the best interests of the corporation, but can the interests of the corporation be best served if the interests of its customers and employees are not paramount?

Shareholder primacy creates problems of short-termism.

As the GFC, and now this Libor case, have made apparent, shareholder primacy and the compensation models that have developed to serve it have been less than successful. Instead, it has resulted in shorter executive tenure, higher executive remuneration and unacceptable levels of assumed risk with little, if any, positive effect on shareholder wealth.

Shareholder primacy becomes even more questionable when it comes to financial institutions.

Banks, such as those involved in setting the Libor, do not operate in a vacuum. The crucial role these institutions play in the stability of the marketplace requires the consideration of the public interest.

This cannot be achieved merely by regulation. What is required is an ideological shift about the purpose of financial institutions. Such a shift will necessitate new leadership qualities and behaviours and a different relationship with regulators, customers and employees. Utopian? Perhaps, but we have to at least question the current dystopia.