Neither a borrower nor a lender be;
For loan oft loses both itself and friend,
And borrowing dulls the edge of husbandry.
This above all: to thine own self be true,
And it must follow, as the night the day,
Thou canst not then be false to any man.
Farewell. My blessing season this in thee.
William Shakespeare, Polonius in
Hamlet, Act I, scene iii
Low growth, low investment, insufficient spend on infrastructure, weak bank lending to the corporate sector, and funding deficiencies of small and medium-sized enterprises are all causes of concern in Europe. To many, they point to fundamental problems in the financing of European companies and in Europe’s financial systems. They have prompted a raft of policy measures, culminating in Jean-Claude Juncker’s €300 billion infrastructure investment programme announced in 2014 and the launch of the Capital Markets Union project by the European Commission to overcome cross-border barriers to investment financing.1
There has been an unprecedented decline in fixed investment in proportion to assets since the financial crisis in France, Germany, Italy, Spain, and the United Kingdom, a decline that is only now beginning to be reversed in some countries. It was greatest in Italy and Spain and least in Germany and the United Kingdom, and it was particularly pronounced in the construction and pharmaceutical sectors.
In analysing the causes of this, economists have exploited the shocks to economies caused by the financial crisis in 2008 and the sovereign banking crisis three years later. What this reveals is that it was companies with high levels of leverage before the financial crisis that cut back their investment the most afterwards. This points to what is sometimes termed a ‘debt overhang’ problem, namely that companies with the largest proportion of debt on their balance sheets were the ones most exposed to the financial crisis that had to respond with draconian cut-backs in their investment and employment.
The problem was not just high levels of overall debt but certain types of debt: companies with the highest proportion of long- as against short-term debt on their balance sheets were the ones most adversely affected by the crisis. This is striking because access to debt finance in general and particularly to long-term debt is often taken to be critical to the financing of long-term investment. A dearth of long-term finance is normally considered to be a deficiency of a financial system in meeting the investment needs of business.
That may well be the case, but long-term debt might be a double-edged sword, as it may also create the most severe constraints on new investment when financial conditions worsen.2 Once put in these terms, the reason is clear: the burden of debt overhang is greatest where the period for which debt endures after a financial crisis is longest. A one-year debt is a millstone around a borrower’s neck; a ten-year debt is a noose.
This points to the need to give serious consideration to ways of constraining the build-up of high levels of corporate debt during periods of benign financial conditions, as well as tackling high levels of debt, most notably long-term debt, during periods of weak financial conditions. And the solution to this is to find means other than contracts to solve the provision of long-term debt to companies. It requires long-term relationships between providers and users of finance not just long-term contracts.
Outside of Europe, the conflict between the benefits of long-term debt and its potential costs is particularly in evidence in developing countries because of their dependence on debt to fund infrastructure investment.3 In general, developing countries have less well-developed domestic bond markets than developed countries, which make them particularly dependent on bank finance. However, their inability to access domestic bond markets may have allowed them to avoid some of the worst effects of the financial crisis that afflicted the developed world.
Another source of funding for the corporate sector, in addition to banks and bond markets, is the corporate sector itself, recycling funds from companies that have surplus financial resources that they cannot profitably employ to firms that have inadequate resources to finance their profitable investments.4 That is precisely what trade credit should offer and in general we might expect that small rapidly growing companies would be recipients of trade credit from large better-endowed suppliers of their inputs.
However, that is precisely what is not observed. In a very telling analysis of flows of trade credit during the Great Recession, it has been observed that far from being recipients of larger amounts of trade credit, small and medium-sized enterprises (SMEs) in Europe increased the net trade credit that they provided to other firms.5 Trade credit did not create a buffer to contraction in bank loans; on the contrary, SMEs found themselves forced to grant more trade credit to large companies. This had real impacts on SMEs’ investment, inventory building, employment, and wages. The perverse outcome reflected the relatively weak bargaining position of SMEs in their trade credit relationships with large firms.
In sum, debt and, in particular, long-term debt present companies with the double-edged sword of funding for investment during good times but the shackles of indebtedness during bad times. Small companies do not have the luxury of accessing markets for their funding and are instead dependent on more short-term and cyclical bank finance. Furthermore, far from being able to call on the resources of their larger and better-endowed big brothers, SMEs find themselves forced to use their scarce funds to support them. They therefore faced a double pincer of bank-lending constraints and increased pressures to extend trade credit to large firms, with adverse effects on their ability to fund investment and employment.
The dependence of SMEs on bank lending makes the role of domestic banks in funding SMEs particularly critical. As described in Chapter 4, it is a role that local banking performed in Britain at the end of the eighteenth and the beginning of the nineteenth centuries. It involved the close relationships between banks and the companies in which they invested that local banking can provide. However, it exposed the local banks to the local economies on which they were dependent and when they failed, so too did the banks. There were therefore repeated banking crises that resulted in the central bank, the Bank of England, promoting the consolidation of British banks through mergers. As they merged, banks shifted their headquarters to London, and the relationships between the banks and the companies in which they invested were severed forever.
Since then, despite repeated attempts to rectify the problem, there has been a persistent deficiency of funding for SMEs in Britain. It is an illustration of how policy intervention designed to solve one problem, namely bank instability, can have unpredicted and unintended consequences for another—deficient bank lending to SMEs. Recently, however, one bank has demonstrated how local banking in Britain is not necessarily reliant on local banks—only it is not a British bank.
One of the most successful banks in Europe is currently the Swedish bank, Handelsbanken. It needed no bail out in either the financial crisis or the Swedish banking crisis. It is one of the highest equity return banks in Europe, and it is one of the fastest expanding banks in the United Kingdom.6 The reason is very clear—in almost every respect it behaves in precisely the opposite way to traditional British clearing banks.7
The first feature of the bank is that it pays its employees no bonuses. Recall that we are routinely told that banks have to pay their employees substantial bonuses for them to be able to compete and retain their best people. Well, here is one of the most successful banks in the world earning substantial returns for its shareholders, paying its bankers no bonuses except the share of profits that they receive on retirement at the age of sixty from the bank’s profit-sharing foundation, Oktogonen—a truly long-term incentive plan.
The second feature of the bank is that it devolves all decision-taking down to the level of individual branch managers, including participation of branch managers in decisions about the largest loans. Branches make decisions about all aspects of their activities including which products they sell, how much they charge, and how they are advertised. Risk is not in general managed centrally but devolved down to the branches, just as used to be normal practice in local banks in which branch managers had real authority.
The third feature of Handelsbanken is its shareholding. Its main shareholders are its profit-sharing fund, Oktogonen, and Industrivärden, a Swedish investment fund, one of whose largest shareholders is Handelsbanken. So Handelsbanken is part of a cross-shareholding in which control resides within the corporation itself. What would traditionally be deemed to be disastrous corporate governance is associated with highly successful, long-term growth and prosperity of the bank.
This is not an isolated case. Evidence from the academic literature suggests that those banks with the best corporate governance arrangements according to conventional measures were the ones that failed the most during the financial crisis and those with the highest-powered incentives were the ones that took the greatest risks.8 Conventional views about corporate governance simply do not apply in relation to either specific examples or evidence from empirical studies of large numbers of banks.
The reason is that in highly leveraged institutions such as banks there is a particularly serious conflict between the two main investors—shareholders and creditors, namely its bondholders and depositors. Shareholders benefit from upside gains but it is the creditors (and ultimately the taxpayers in systemically important institutions) who bear the downside losses that force banks into bankruptcy. Remuneration structures that reward management for pursing shareholder interests are in conflict with those of creditors.
The way in which regulation has sought to address the problem of excessive risk-taking by banks is by encouraging them to monitor and manage their risks through central risk committees. There is indeed evidence that banks with strong risk controls took fewer risks than other banks during the financial crisis.9 However, whether it is desirable is highly questionable. The first point is that, while it can be done, it is difficult to do well. Anyone who has been involved in risk committees knows how difficult it is to monitor risks centrally, and risk committees are prone to failure because of the complexity of the management task that they are expected to undertake.
Second, central management of risk is a source of systemic risk itself, not a way of mitigating it. If risk is managed centrally then when a failure emerges in one part of the bank it will be indicative of an institutional failure throughout because everyone is following the same management practices. It is similar to the argument suggesting that systemic risk is created when central banks and regulators impose prescriptive management rules on banks.10 As soon as one bank fails then the market should quite correctly infer that the whole applecart is rotten because everyone is managing risks in the same way.
Third, centralized risk committees discourage banks from doing what they should be doing. They start from the presumption that the purpose of a bank is to limit risk. That is as wrong as the argument that the purpose of a bank is to maximize its shareholders’ value. The purpose of a bank is to do things: to lend money and to screen and monitor borrowers, in particular where financial markets cannot or do not perform these functions. Criticism of British banking’s failure to support small and medium-sized companies is illustrative of the problem. It has become more vocal since the financial crisis of 2008 and that is exactly what one would expect. If risk control is regarded as a primary objective and banks are penalized for taking it by being required to hold capital in proportion to their risk-weighted assets then they stop taking risks.
So the starting point behind risk committees is wrong. But so too is its approach. The way that Handelsbanken became a highly prudent, safe bank was not through its risk committee. It was exactly the opposite. It was through delegating not centralizing decision-taking. How did it do that? Two things. First it devoted a great deal of effort and attention to selecting people—people it could trust to act intelligently, prudently, and according to the principles and values of the bank. Second, it instilled a strong common culture about the purpose and values of the bank so that everyone was aware of how they were supposed to behave and what was acceptable conduct.
That is the way in which every successful organization in the world works. It is the way in which we bring up our families and children. We do not employ a risk committee to manage them. We educate and instil a strong sense of purpose and then we leave them to get on and run their own lives. Successful organizations operate in exactly the same way.
There are two exceptions. The first is when those in whom we have placed trust fail us. That is what happened during the financial crisis. The result was the largest banks in Britain were effectively if not formally placed in administration. And because banks no longer trusted those working for them, they effectively in turn put their entire organizations into ‘special measures’ transferring oversight and control to central committees and boards. As a short-term expedient it may have been necessary but as a way of running a bank it was disastrous. It extinguishes innovation, it creates systemic risk within banks and across financial institutions, and it stops banks doing what they are supposed to be doing.
If risk committees and risk officers were the ways of avoiding bank failures, it is hard to imagine that they would not have been invented some 700 years ago when banks first became established in Europe. That is not to say they should never be observed anymore than it is correct to say that central banks should never be involved in overseeing bank risks. They have a vital role to play in relation to one specific type of risk—aggregate systemic risk. Those risks that individual banks or individual divisions or branches of banks cannot observe or control themselves need to be centrally monitored and managed. A failure to do so is a failure to internalize an important externality within and across institutions and an abrogation of responsibility on the part of both banks and central banks.
That is what the board and risk committees of well-run banks like Handelsbanken do. They are embedded in the banks’ strategy to avoid excessive concentrations of activity in particular areas, to provide early warning of where risk concentrations are becoming excessive, to insure that those aggregate risks are hedged, to be able to establish whether failures are due to idiosyncratic random losses or a failure of management, and, where it is the latter, to intervene and change management. That is precisely what central risk committees should be doing within organizations and what the central bank should be doing in relation to the financial system as a whole.
But that is a very different mindset from saying that the purpose of a risk committee is to control risk. The only thing that we know from evidence on corporate governance and boards is that we do not know. We do not know what is the right way of managing risks. And the reason we do not know is that there is not a right way or a single best form of corporate governance and we should stop behaving as if there was. We should start to learn from cases of success such as Handelsbanken that there is not a simple toolkit for managing bank risks and that many of the worldly wisdoms we take for granted—one has to pay bonuses, one should centralize authority, one should expose banks to the market for corporate control—are neither worldly nor wise.
One of the reasons for Handelsbanken’s success in the United Kingdom is its focus on the customers who are least well serviced by existing British banks, namely SMEs. It is a highly purposeful and committed bank, filling a gaping hole in the UK financial system left by the demise of local banks by essentially recreating them, albeit in the context of a multinational bank. But it is a lender and therefore does not fill another gap in the SME market and that is the equity gap.
Some aspects of this have already been addressed through the rise of private equity. Europe’s problem in financing high tech firms is no longer so much at the start-up phase of providing venture capital finance and in many respects Europe has caught up with the United States in the early stages of funding through venture capital.11 Rather, it is in the later stages of scale-up to ‘unicorns’, i.e. start-up companies valued at more than $1 billion, where Europe still lags behind the United States. That failure reflects a combination of insufficiently large amounts of funding at later rounds, less well-developed markets for both primary funding and secondary trading of SMEs equities, and a tendency for European firms instead to sell out to acquirers. It is in transitioning from start-up to scale-up where European firms fail.
New markets for trading equities of SMEs are beginning to emerge in a number of European countries. These are encouraging the use of equity finance by SMEs but they remain relatively underdeveloped. The reason why scale-up is underprovided is that it is at this stage that the combination of private control to preserve idiosyncratic value with access to public equity capital is required. Public markets without dominant shareholders exist in the United Kingdom and private family control is widespread in Continental Europe, but it is the combination of the two that is required to promote purposeful well-funded companies.
The attraction of a parallel system of block-holder control with public equity as described in the discussion of family ownership in Chapter 4 is that it does not require institutional and other investors in public equity to invest for the long term. Only the block holders, be they families or institutions, need to commit to the long term. Meanwhile, public markets can and should encourage trading to provide price information as well as liquidity for investors.
Public markets perform the further important function described in the previous chapter of managing risks. Growth of mutual funds and exchange-traded funds (ETFs)—marketable securities that track baskets of assets such as commodities, bonds, or stock market indices (like the FTSE 100 and S&P 500 indices) and trade like common securities—has allowed investors to diversify their risks of investing across the world at low costs of transacting. While block-holder control promotes the creation of idiosyncratic values, public equity markets dissipate their risks across large diversified portfolios of securities, thereby reducing their costs of funding to levels commensurate with low-risk investments. Public markets therefore allow idiosyncratic value of human, natural, and social as well as material capital to be created at low costs of financial capital.
Through their powers to tax, governments are often thought to have the ability to pool risks more widely than private capital markets. However, with the rise of mutual funds and ETFs, private markets have been able to achieve levels of international diversification that extend well beyond the jurisdiction of individual governments. This may have reduced costs of funding social and natural capital investments to levels that are now below those achievable by public sectors. However, there are two serious impediments to this parallel development of committed long-term ownership and liquid stock markets. The first is the corporate tax system.
Corporate tax systems differ appreciably around the world; however, there is one feature of them that is universally observed and that is the encouragement they give companies to employ debt finance in preference to equity. This results from the feature of corporation tax that allows companies to deduct interest payments on their debt but not their payments of dividends on their equity from their taxable income in determining their corporate tax liabilities. In the process, they provide a powerful incentive to both banks and companies to fund their activities through debt rather than equity.
Like so many irreversible distortions to tax systems, full interest deductibility of interest payments had its origins in a temporary expedient, in this case in a response to the 1918 introduction of a WWI ‘excess profits’ tax in the United States.12 Interest deductibility was accepted as a temporary measure to compensate for the exclusion of ‘borrowed funds’ from the definition of invested capital on which excess profits were computed. But when the excess profits tax was repealed in 1921, full interest deductibility was retained in the corporate income tax that replaced it.
It is nonsensical. It has resulted in debt addiction of the corporate sector and encouraged over-borrowing and over-lending in the financial sector, exposing it, as well as the corporate sector, to failure. We should look to equalize the tax treatment of equity and debt in the corporate tax system, firstly to encourage banks to hold more equity and secondly to encourage companies to hold less debt. This would promote better-capitalized banks and less-leveraged corporations.
In fact, the distortion is even greater than that of the tax deductibility of interest payments because it is often accompanied by a plethora of other policies and incentives that encourage companies to borrow even more. Take for example the loan guarantee schemes that exist in many countries by which the government bears at least some of the risks associated with bank-lending to SMEs. One study exploited the considerable variation both across firms and time in the availability of loan guarantees in the Netherlands after the financial crisis to examine the impact of loan guarantees on a large sample of individual firms.13 It found evidence that the introduction and then subsequent withdrawal of the loan guarantee programme had a substantial effect on the number of loan applications from companies, and that firms eligible for loan guarantees applied for more loans than those that were not.
In that respect, the loan guarantee scheme operated as intended. However, the study also found that banks accepted less collateral from and made riskier loans to firms covered by the loan guarantee scheme, suggesting that loan guarantees reduced the incentive on banks to screen and monitor the quality of the loans they were making. In that regard loan guarantees further distorted the allocation of bank credit.
Evidence in support of at least eliminating existing distortions comes from studies that have examined the impact of tax reforms introduced to eliminate corporate tax discrimination between debt and equity. One study analysed tax reforms introduced in Italy and Belgium in 2000 and 2006 respectively that decreased the cost of equity to banks and firms.14 The reforms allowed banks and companies to deduct a notional return on their equity as well as their debt capital in computing their taxable profits, thereby reducing the tax incentive to issue debt in preference to equity. The decrease in the cost of equity capital for banks in Belgium and Italy led them not only to raise the proportion of equity relative to debt on their own balance sheets but also to lend more to firms in another country. Conversely, when the reforms were reversed, there was a decrease in lending by these banks, suggesting that the elimination of the tax distortion is a powerful mechanism for addressing debt overhang.
Elimination of the deductibility of interest payment on corporate taxes, potentially offset by compensating reductions in corporate tax rates to avoid a corresponding increase in corporations’ tax burdens, is an extremely straightforward way of correcting a major distortion in our financial systems.15 But it is not just taxation that is undermining the use of equity finance by the corporate sector––so too is regulation.
Public policy to the corporation has been dominated by an overriding concern—the ‘agency problem’ of aligning the interests of managers with those of their shareholders to avoid unprofitable growth or undue complacency. The common response has been the strengthening of shareholder rights. There has been a marked increase and convergence in investor protection in all major industrialized countries over the past twenty years. In some countries, such as China, Germany, and the Netherlands, it has been very pronounced. In others, such as the United Kingdom and United States, shareholder protection was already well established at the beginning of the 1990s and has only experienced modest changes since then.16
The justification for the strengthening of shareholder rights is twofold. First, in the context of dispersed ownership systems, such as those in the United Kingdom and the United States, it provides a countervailing power to that of corporate executives and managers who control corporate assets. Second, in more concentrated ownership systems that are commonplace outside the United Kingdom and United States, it gives minority investors protection against the dominant shareholders, in particular families, who can exploit their power to the detriment of other shareholders.
If equity markets are to operate efficiently as allocators of resources and monitors of the use of capital, then minority shareholders as residual claimants need to have the means of protecting themselves against both management and dominant shareholders—a truth recognized in nearly all countries.17 Their rights therefore ensure that the policies and practices of companies are consistent with value creation not value diversion for the benefits of vested interests.
However, an emphasis on minority-shareholder protection comes at a price. It curtails the ability of owners to exercise direct and effective governance, and it prevents management from freeing itself from the tyranny of control by the market. In particular, it limits the ability of companies to establish the type of dual-ownership structures described in Chapter 4 by which block holders provide anchor shareholding while the remaining shares are freely traded on stock markets. It discourages these arrangements by raising the cost of being a controlling shareholder. It therefore undermines companies’ ability to structure their ownership and governance in a form that is best suited to their activities. While promoting the interests of minority shareholders, investor protection can therefore have unintended and seriously detrimental effects on corporate development.
Examples of such unintended consequences are insider-trading rules discouraging investors from active engagement for fear of making themselves insiders; rights issues requirements preventing companies from placing blocks of shares with committed long-term investors; pension-fund valuation and insurance-company solvency rules discouraging institutions from holding equity capital; removal rights of shareholders preventing companies from committing to the long-term employment of directors; stock-exchange-listing rules discriminating against the issuing of shares that confer disproportionate voting rights on committed shareholders; and takeover defence restrictions preventing companies from protecting themselves against short-term arbitrageurs during takeover bids.
This is not to say that there may not be a strong justification for each of these rules and that on balance they may have beneficial effects. However, it warns that regulation should not prescribe either in favour or against particular corporate arrangements. It should as far as possible adopt the same neutral position that is advocated for taxation, namely neither encouraging nor discouraging companies from adopting certain types of financial structure or investment policy. There should be functional equivalence and it should be for investors and stakeholders to determine their appropriate corporate forms, not for regulators to prescribe them.
A principle of neutrality flushes out adverse consequences of existing regulations but it does not achieve the positive results of enabling legislation. While the United Kingdom and United States are frequently regarded as having similar, stock-market-oriented, capitalist systems, their differences are as pronounced as their similarities. One of the most important distinctions is the greater degree of diversity of legal structure and corporate form in the United States than the United Kingdom. This in large part derives from the fact that much corporate legislation in the United States is formulated at a state rather than a federal level.
In that regard, the diversity in corporate form and legislation that exists across Europe might be a more appropriate benchmark than that in the United Kingdom. Freedom of incorporation across EU member states in principle provides at least as great a degree of variation as exists in the United States. However, one of the consequences of a withdrawal of the United Kingdom from the European Union would be that this variety might no longer be available to UK firms. This emphasizes the importance of diversity at the national as well as the supranational level.
It is sometimes suggested that UK company law achieves this by its permissive nature, namely that S.172 of the 2006 Companies Act permits companies to adopt almost any structure that they choose. But this is incorrect on two scores. First, there are hidden elements of discrimination, regarding, for example, the election and removal rights of shareholders to appoint and replace their boards of directors, which render mechanisms such as staggered boards that are commonplace in the United States infeasible in the United Kingdom. This is illustrative of why the adoption of a principle of neutrality is potentially of considerable significance.
Second, and more significantly, the Companies Act fails to identify what should be the primary objective of every firm: to promote and achieve their purposes. It does not even require companies to articulate their purposes in any meaningful way, as illustrated by the case of Unilever in the introduction to this part of the book. Instead, by promoting ‘the success of the company for the benefit of its members’, the Companies Act encourages a focus, albeit not an exclusive one, on the interests of shareholders. It is therefore constraining in discouraging other purposes.
Even if there were no such forms of discrimination intended or otherwise, a permissive law is not the same as a facilitating one. In particular, what the United States illustrates is how the adoption of laws at a state level has encouraged the development of the judicial expertise that is required for the enforcement of different types of corporate form. To place this in a European context, German courts know how to enforce German-style corporate laws and Swedish courts understand Swedish laws. Without the prod that comes from public law, certain types of arrangements would simply never get off the ground because they would remain unfamiliar to lawyers and courts.
As argued in Chapter 7, this points to the importance of public laws and regulations in promoting, not just permitting, different types of arrangements. For example, it is sometimes suggested that it is not necessary for the United Kingdom to adopt a ‘Benefit Company’—a company that has a stated public or social as well as private purpose—because it can be achieved under the 2006 Companies Act. However, the Act may not achieve the same outcome as a Benefit Company because of the substantial costs and risks involved in being a first mover in its adoption. In other words, innovation in public law is required to achieve innovation in corporate form.
Policy should therefore seek to promote companies of varied legal structures. This is key to the successful development of purposeful companies and financial institutions because supportive legal structures are critical to their formation. It is not the structure of a corporation that is offensive, any more than it is the genetic make-up of an individual, but the potential actions that either may take. The combination of enabling corporate law that promotes company purposes and purposeful regulation that avoids those that are socially detrimental is the key to the creation of purposeful firms and financial systems.
The law cannot force good conduct, but it can prevent or promote it. It can be prescriptive and restrictive, or enabling and facilitating. When it is the former it should be focused on offending purposes and functions and when it is the latter it should identify and promote corporate commitments to purpose. And there is one straightforward way in which it can do this. It should require companies not only to articulate their corporate purposes but also to incorporate them in their articles of association and demonstrate how their ownership, governance, values, culture, leadership, measurement, incentives, and performance promote the achievement of and commitment to their corporate purposes.
The act of incorporating corporate purposes in articles of association and requiring firms to demonstrate how their corporate structures and conduct deliver on them could have a transformational effect on the corporate sector and financial system. It would shift the onus of director fiduciary duties to where they should be on corporate purposes. They would require not only directors and management of companies to demonstrate commitment to purpose but also all external parties related to the firm to do likewise. For example, it would encourage institutional investors to demonstrate a commitment to promoting the purposes of the companies in which they invest as well as to their investors.
Repositioning equity at the centre of corporate finance through neutral and enabling taxation and regulation re-establishes the relation between corporate finance and governance. Equity is not just a source of finance but also of voting control and as such is the dominant influence on the governance of firms. Shareholders are the pipers who call the corporate tune and the reason why companies are required not just to earn profits but also to maximize them at all times. In determining whether they should do well by doing good, companies have to demonstrate that they not only do well but they always do the very best that is possible for their shareholders. It is this continuous emphasis on doing the best for shareholders that militates against doing good—the best is literally the enemy of the good.
In some circumstances it is perfectly appropriate for companies to be expected to maximize their return on equity. Where constraints on the availability of financial capital exist so that it has to be rationed then it is correct to suggest that capital should be allocated to those activities that yield the highest returns for investors. If that is not done then a scarce resource is being inefficiently employed and could be better reallocated elsewhere. But where such constraints do not exist then there is no need to ration capital and only finance the highest-return activities.
Financial capital was once the major constraint on investment. In particular during the third age of the corporation when it was associated with manufacturing there were large demands for financial capital to fund physical investments in buildings, plant, and machinery. This is why external finance from local banks and then local stock markets played such an important role in the industrial revolution and the subsequent emergence of Britain as ‘the workshop of the world’. However, as corporations have since then progressed to their fourth age of service firms and in particular financial services, limitations on capital have been relaxed. As they have moved to their sixth and current age of mindful corporations, the capital requirements of businesses have dwindled further to insignificance.
So while financial capital was once in short supply, it is no longer. On the contrary, it is in abundance and the world is awash with financial capital in search of profitable activities to fund. That is one of the reasons for the very low rates of return that savers currently earn on their investments. It may also be a cause of a striking feature of finance: the amounts of finance that companies in aggregate raise from stock markets is less than the amounts that they hand back to their shareholders in repurchases of their own shares and acquisitions of shares in other companies.18 This is true around the world but it is particularly true in the two countries with supposedly some of the best-developed stock markets—the United Kingdom and the United States—and it is intensifying with the growth of share repurchases. The adverse tax treatment of equity in relation to debt is one possible reason for this, regulation of equity markets may be a second, but declining financing requirements of corporations may be the most important.
It is no longer finance where companies’ most acute shortages lie—it is the supply of skilled labour to provide the minds behind mindful corporations, trust and cohesion among their communities and customers, and clean environments and preservation of natural capital that present business with their most serious challenges. In other words, it is human, social, and natural capital that are the scarce resources of the twenty-first century, not financial capital.
While shareholders were therefore legitimately once the pipers who called the company tune and required companies to maximize their capital value, this is no longer the case. They should have relinquished their pipes to others, and it is an anachronism to affiliate control with equity. That is why it is important that the law does not presume it to be so and regulation does not impose it; instead, both should encourage recognition of the growing significance of other forms of capital.
Underlying this is recognition of the interdependence between finance and investment that contrasts with the conventional view of a separation between the two. The conventional notion stems from a highly influential and cited economic theory of the irrelevance of finance to investment—the Modigliani and Miller theorem.19 It is based on simplifying assumptions of complete, costless, and taxless financial markets that both this and the first chapter have suggested clearly do not apply in practice. It has promulgated a belief that the functioning and regulation of the financial system can be considered separately from the ‘real side’ of the economy—the corporate sector.
This has created what might be termed ‘left side of the balance sheet (asset) paralysis’, namely everyone in the asset-management and corporate chain is beholden to their liabilities—asset owners (e.g. pension funds) to their beneficiaries (pensioners), asset managers (fund managers) to their asset owners, boards of companies to their asset managers, senior management to their boards of directors, and workers to their managers—ignoring assets lower down in the process. It has created an attitude of deference and subservience to those above that has converted what superficially resembles democratic participation in the rewards of share ownership by the population at large as investors and pensioners into an autocratic system of control by superiors.
As Chapter 8 reveals, this has resulted in regulation that considers the functioning of the financial system in Wall Street and the City of London as separate from the corporate sector in Main Street and Manchester. As a consequence, financial regulation has paid insufficient attention to how, in protecting the owners of corporate liabilities, it afflicts the managers of assets in which they invest.
Requiring companies and financial institutions to demonstrate how they fulfil their purposes by establishing durable relationships between each other is a powerful mechanism for addressing the problem. It builds the partnerships that are required to reverse the separation between finance and investment that economic theory and financial policy have encouraged. It addresses left side of the balance-sheet paralysis by encouraging a turn to the right.
In sum, policy has privileged debt over equity through corporate tax, minority over anchor shareholders through regulation, and shareholder over human, social, and natural capital through corporate law. It is no wonder we are in a mess with over-indebted corporations and financial institutions, an absence of committed long-term shareholders, and avaricious shareholders exploiting other stakeholders.
We need to restore taxation, regulation, and the law to neutrality through functional equivalence, away from privileging a small stratum of society, towards enabling companies to adopt corporate structures that are suited to the delivery of their purposes. We should require companies to incorporate their purposes in their articles of association and demonstrate how their corporate structures and conduct, and those of all parties with whom they are related including their investors, assist them in discharging their duties to deliver on their purposes.
Tax, regulatory, and legal reform are key to addressing financing and control of our corporations. However, the role of the state in fulfilling its part of the bargain does not stop at incentivizing, permitting, and enabling corporations to adopt structures that promote the public as well as the private interest. It extends to erecting the economic superstructures on which private companies depend. While economic theory and current policy view finance and investment, private and public, and commercial and social as separate domains accountable to different people and organizations, they are in fact intimately interrelated and intertwined in the creation of the core component of economies—their infrastructure.