The Ethics of Banking: Conclusions from the Financial Crisis (Issues ...

144 9 Financial Wagers, Hyper-Speculation and Shareholder Primacy
which end up being inimical to the interests of other stakeholders. If shareholders
and managers form a single stakeholder group with the common interest of increasing
their income by means of the firm’s share price, the managers will be tempted to
make decisions in their own and the shareholders interests to drive up the share price
at a cost to the firm and to the detriment of the other stakeholders. The upward trend
in executive pay in British state-owned enterprises after these were privatized and
reorganized as joint-stock or limited liability companies speaks volumes. The most
prominent consequence of the privatization of these firms was the escalation of their
managers’ salaries to multiples of their previous levels. Equally, the high bonuses
of the finance industry can be seen as a result of a one-sided fusion of shareholder
and management interests.
Nevertheless, blame for the hyper-speculation in recent decades and the resorting
to risk-laden business strategies cannot be laid at the door of the managers
alone. They were spurred on and “incentivized” by their shareholders. The one-sided
emphasis of shareholder value seemingly legitimized the shareholders in imposing
their ideas of profit maximization and high-risk strategies on the managers, who in
turn relied on the shareholder primacy principle to justify their strategies. That principle
can indeed be credited with primacy in the genesis of false incentive structures.
It is therefore necessary to change the system of rewards, not only for managers but
also for shareholders. 38 If, based on the shareholders’ limited liability 39 for the firm,
they are incentivized to expect a high level of management risk-taking, any negative
consequences of which cannot affect them beyond the amount of their share capital,
i.e. liability is limited, whereas they participate fully in the high profits, they will
always demand a strategy involving (unduly) high management risk-taking. If both
shareholders and managers also know that the state will bail them out of a banking
insolvency, they will entertain even higher risks. An increase in the liable capital
of banks, i.e. in shareholders’ equity capital, is therefore an indispensable imperative
for improving the corporate governance and for stepping up the liability of
shareholders and managers. If the shareholders stand to lose more equity capital, if
they bear a higher risk themselves, they will encourage the managers to tone down
their business risk-taking. If the shareholders bear minimal risk and minimal liability
for losses, the managers will be unable to stand up to them, even if the managers
themselves are more risk-averse.
The demand to maximize shareholder value created incentives for management
to pay more attention to speculative gains in their company’s share price than to
the profit from superior productivity and products. These incentives can become
perverse incentives because the value of shares on the stock market is not the perfect
38 The same is demanded by SINN (2009), p. 307.
39 Sinn attributes the principle of limited liability a pivotal role among the causes of the financial
crisis. He talks about the bacillus of limited liability (“Bazillus der Haftungsbeschränkung”; SINN
[2009], p. 290). He argues that the limitation of liability creates incentives among those involved to
take excessive risks, and claims that this process was exacerbated by diminishing liability further
through deregulation and the reduction of the equity to balance sheet total ratio or capitalization
requirement.