Andrew G Haldane: Who owns a company?
Speech by Mr Andrew G Haldane, Executive Director and Chief Economist of the Bank of
England, at the University of Edinburgh Corporate Finance Conference, Edinburgh,
22 May 2015.
* * *
The views are not necessarily those of the Bank of England or the Monetary Policy
Committee. I would like to thank Jeremy Franklin, Conor Macmanus, Jennifer Nemeth, Ben
Norman, Peter Richardson, Orlando Fernandez Ruiz, John Sutherland, Ali Uppal and
Matthew Willison for their help in preparing the text. I would also like to thank Andrew Bailey,
Mark Carney, Iain de Weymarn, Sam Harrington, Alan Murray, Rhys Phillips and David Rule
for their comments and contributions.
Introduction
This might seem like a simple question with a simple answer. At least for publically listed
companies, its owners are its shareholders. It is they who claim the profits of the company,
potentially in perpetuity. It is they who exercise control rights over the management of the
company from whom they are distinct. And it is they whose objectives have primacy in the
running of the company.
This is corporate finance 101. It is the centrepiece of most corporate finance textbooks. It is
the centrepiece of company law. It is the centrepiece of most public policy discussions of
corporate governance. And it is a structure which, ultimately, has survived the test of time,
having existed in more or less the same form for over 150 years in most advanced
economies.
That the public company has been a success historically is not subject to serious dispute. It
was no coincidence that its arrival in a number of advanced economies, in the middle of the
19th
century, marked the dawn of mass industrialisation. The public company was a key
ingredient in this second industrial revolution. Perhaps for that reason, the public company is,
in many people's eyes, the very fulcrum of capitalist economies.
Yet despite its durability and success, across countries and across time, this corporate model
has not gone unquestioned. Recently, these questions have come thick and fast, with a
rising tide of criticism of companies' behaviour, from excessive executive remuneration, to
unethical practices, to monopoly or oligopoly powers, to short-termism. These concerns
appear to be both strongly-felt and widely-held.
Among the general public, surveys suggest a majority do not trust public companies,
especially big companies.1 Among professional investors, sentiment is well-encapsulated by
the following quote from Larry Fink, CEO of Blackrock - the world's largest asset manager -
in a letter sent to the Chairmen and CEOs of the top 500 US companies earlier this year:2
"[M]ore and more corporate leaders have responded with actions that can deliver
immediate returns to shareholders, such as buybacks or dividend increases,
while underinvesting in innovation, skilled workforces or essential capital
expenditures necessary to sustain long-term growth."
Among academics, John Kay's UK government-initiated review into short-termism in equity
markets and their effect on listed companies (Kay (2012)), Colin Mayer's Firm Commitment
(Mayer (2013)) and Lynn Stout's The Shareholder Value Myth (Stout (2012)) each raise deep
and far-reaching questions about the purpose and structure of today's companies.
Are these concerns legitimate? What is their precise micro-economic source? And are they
now of sufficient macro-economic importance to justify public policy intervention? To answer
those questions, it is useful to start with the origins of modern-day companies, before looking
at the potential incentive problems among stakeholders embedded in those structures.
Finally, I consider public policy actions that might mitigate these problems.
These problems are not specific to any industry. But banks' balance sheets and governance
structures mean they may be especially prone to these incentive problems. So I will use
them to illustrate some of the micro-economic frictions and their macro-economic impact.
Indeed, it is no coincidence that the most significant changes to corporate governance
practices recently have been within the banking sector.
A short history of companies
Let me begin by defining "corporate governance" in its broadest sense: as the set of
arrangements that determine a company's objectives and how control rights, obligations and
decisions are allocated among various stakeholders in the company (Allen and Gale (2000)).
These stakeholders comprise not only shareholders and managers, but also creditors,
employees, customers and clients, government, regulators and wider society.
Over the past two centuries, several dozen pieces of company legislation have been enacted
in the UK alone. This legislation has successively defined and redefined these purposes,
rights and obligations among stakeholders. This legislative path has been long and winding -
Table 1 provides a summary. It has been shaped importantly by the social, legal and
economic climate of the day. And it is the interplay between these contextual factors that,
through an evolutionary process, has delivered today's corporate governance model.
Moving to incorporation
Tracing definitively the origins of what today are called companies is not straightforward. It is
possible to sketch a timeline stretching back at least to Rome around 700BC to find
something resembling a company (Shelton (1965)). Certainly, by the sixth century AD a
number of corporate entities were codified in Roman Law (Moyle (1913)).
Modern concepts of tradable "shares" in companies appear to have emerged in the
mid-thirteenth century in continental Europe. In England, early methods of incorporation were
set out in a common law case in 1615: incorporation was a privilege bestowed by the state,
either by a Royal Charter or a private Act of Parliament.3 At least in principle, this meant a
company was incorporated with public good objectives in mind.
A prominent early example of such a company was the Bank of England. It was established
in 1694 under both a Royal Charter4 and an Act of Parliament.5 The Charter establishing the
Bank made clear that its purpose was "to promote the public good and benefit of our people".
And so it remains today.
But this incorporation process was costly, lengthy and cumbersome. It was also subject to
favouritism and abuse. Lawyers and businessmen began to find legal loopholes allowing
them to found companies while remaining unincorporated. These unincorporated entities
were generally small partnerships, whose members both owned and controlled the company
and faced unlimited liability.
This model was an incentive-compatible one. It delivered a close alignment between the
interests of directors and shareholders - typically, they were one and the same. Meanwhile,
unlimited liability created sharp incentives among owners to avoid insolvency as typically
their very livelihoods depended on it. And this, in turn, helped protect wider stakeholders,
including creditors and customers, from company risk.
From unlimited to limited liability
19th
Times were, however, changing. Approaching the middle of the century, the era of mass
industrialisation was dawning. Pressures to expand companies, financed by larger pools of
capital, began to mount. Unlimited liability was felt by some to create an insurmountable
barrier to such expansion, inhibiting prospective deep-pocketed investors from putting their
money into unlimited liability ventures.
As Liberal MP William Clay said in 1836 "unlimited liability has a tendency to deter persons
of fortune, intelligence and respectability from becoming partners or managers of joint-stock
banks". Walter Bagehot attacked unlimited liability on the grounds that its financial benefits
were illusory, as most shareholders simply did not have deep enough pockets to make good
prospective losses (Bagehot (1862)).
International practices were also shifting. Limited liability had been introduced in parts of
17th
continental Europe from the century onwards. It had also begun its journey across the
Atlantic, with Connecticut and Massachusetts adopting it from 1817 (Haldane (2011)).
In 1854, a Mercantile Law Commission in the UK reported on its review into limited liability.
Its verdict was clear: "although the details of our mercantile laws may require correction...it
would be unwise to interfere with principles which...have proved beneficial to the general
industry of the country" (Johnson (2013)). In short, the costs of limiting liability outweighed its
benefits.
It was to no avail. A well-connected, and newly wealthy, middle class was eager to protect its
riches when owning and investing in business (Ireland (2010)). And an eager-to-please
political class was keen to expand business to stimulate economic activity (Blumberg
(1986)). Parliament passed the Limited Liability Act in 1855.
With limited liability, incentives to avoid insolvency were no longer so sharp. As share
ownership widened, directors and shareholders became distinct entities. In the eyes of the
law, a share was no longer an equitable interest in a company's assets (Ireland (2010)).
Instead it was a residual claim on its future profits. A Rubicon had been crossed.
Britain's early banks
Interestingly, banks followed a somewhat more circuitous route, albeit to the same end-point.
Until 1826, the number of partners in a note-issuing bank in England was limited to six. The
six-partner rule for English banks was relaxed in 1826. But it was not until 1858 that English
banks were allowed to limit their liability, three years after non-financial institutions. This was
recognition that the risks posed by banks were on an altogether greater scale.
Even after legislation was passed, the initial response by banks was lukewarm. Their
directors fretted about the signal that limited liability sent to depositors. That concern was
reinforced when Overend and Gurney failed in 1866; it had adopted limited liability just
months before its failure. For the eleven British banks with unlimited liability that failed
between 1836 and 1878, every depositor had been paid out in full (Turner (2014)).6
Shareholders' willingness to do so was helped by them vetting share transfers to exclude
owners without sufficient funds. Indeed, banks' shareholders remained liable even after they
had sold their shares: in Scotland, former shareholders were liable for debts incurred when
they had been a shareholder, while in England and Ireland a shareholder remained liable for
three years after they had sold their shares (Button et al (2015)).
But critics of unlimited liability for banks were becoming increasingly vocal. George Rae, an
19th
Aberdonian who became a prominent banker during the century, feared that "men of
wealth and position would gradually sell out" such that unlimited liability was reduced to "a
husk without its kernel" (Rae (1885)).7 The tide was gradually turning.
In 1849, only the five original joint-stock banks set up by state charter - the Bank of England,
the
Bank of Scotland, the Royal Bank of Scotland, the Bank of Ireland and the British Linen Bank
- were statutorily permitted to operate with limited liability. By 1869, roughly a third of British
banks had limited their shareholders' liability.8
But it was the failure of the City of Glasgow Bank in 1878 that precipitated a decisive shift
away from unlimited liability.9 Such a large proportion - 86% - of its shareholders were wiped
out that a public relief fund was set up to support them. As The Economist reported at the
time, "the share lists of most of our banks exhibit a very large - almost an incredible -
number of spinsters and widows" (Button et al (2015)).
The Companies Act 1879 introduced a different liability concept - reserve liability - under
which a shareholder was liable to meet a bank's debt up to a fixed multiple of their equity
investment in the case of its failure. This was analogous to the double-liability system
adopted for US bank shareholders at the time.10 By 1889, all bar two British banks had
limited their shareholders' liability and nearly two-thirds had opted for reserve liability.11
But even reserve liability was felt to be precarious, stoking rather than abating banking
crises. As Bank of England Deputy Governor Catterns stated in a secret memo of 1937
"today a bank could not in a crisis make a call on shareholders without aggravating the
crisis".12 In the 1950s, the major British banks eliminated their remaining uncalled capital
(Turner (2009)).
Entrenching shareholder rights
Yet, even once firmly rooted, limited liability quickly gave rise to a new set of questions. If
managers were no longer personally liable for failure, what incentivised them to protect
investors' money? And what provided the incentives for shareholders, increasingly dispersed
and with their claims protected from downside risk, to remain engaged?
19th
In the century, maximising shareholder return was not the centrepiece of companies'
objectives or directors' duties. To be sure, paying a regular dividend was important and
shareholders could - and often did - challenge directors regarding its size. But wider
considerations played as important a role.
Introducing his reflections in 1885 on "the rights and duties of shareholders", George Rae
observed that "when a man becomes a shareholder in a bank he becomes to all intents and
purposes a co-partner in the business transacted by it. True, he is only one partner amongst
a thousand others in your Bank; but that does not release him from the obligation of doing
what he can for the common good" (Rae (1885)).
Walter Leaf, chairman of Westminster Bank Ltd, writing in the 1920s remarked: "The
confidence in British banking which has been acquired by long experience is mainly due to
the sense that Directors have conducted the business of their banks with constant attention
to public interests in the first place" (Leaf (1937)). The public good remained centre-stage in
companies', and in particular banks', objectives.
Yet even as Rae and Leaf were writing, shareholders' focus on returns was sharpening. Rae
comments: "There are shareholders to be found here and there, to whom their own Bank
would appear to be a hostile institution, which it is their business to attack on the slightest
pretext... He is disappointed with the dividend, and objects to the balance carried forward to
next year as excessive" (Rae (1885)).
The legal framework underpinning companies was also starting to fray. It had failed to keep
pace with the boom in the number of shareholders and their quest for dividends. Cases of
company fraud began to proliferate (Ireland (2010)). In 1848, Arthur Smith published a
pamphlet where he uncovered that most railway companies - the poster child for the modern
corporation - were in fact profitless and paying dividends to shareholders out of capital
(Smith (1848)).
The law responded with a number of measures to protect shareholders. These included the
requirement for companies to disclose information about their operations, such as through
company accounts, and powers for shareholder to sue directors (Bryer (1993)). These were
augmented with shareholder General Meetings (GM), the forerunner of today's Annual
General Meetings (AGMs).
Initially, shareholders' voting powers at these GMs varied significantly. In a sample of
pre1850 companies, 233 different shareholder voting systems were found. The Companies
Clauses Consolidation Act of 1845 set as the default voting structure a graduated system of
shareholder rights, in which rights reduced according to the scale of shareholding. But during
19th
the course of the century, the "one share, one vote" voting model familiar today gradually
came into the ascendency (Freeman et al (2012)).
Shareholder primacy
Accompanying this rise in shareholder rights was a steady rise in acceptance of shareholder
primacy as the key objective of a company, at least in the UK and US. A number of legal
case decisions, on both sides of the Atlantic, saw this objective enshrined.
In the UK, the case of Hutton vs West Cork Railway Company in 1883, the company had
been wound up and yet still resolved to pay directors for their past service. Shareholders
successfully challenged these awards on the grounds that they did not benefit the company
which, crucially, was interpreted to mean its shareholders (Mukwiri (2013)).
In the US in 1919, a case against Henry Ford was brought before the Michigan Supreme
Court by the Dodge brothers, a minority shareholder. They challenged Ford's decision to
reinvest the firm's profits to expand the business and pay better wages, which they felt
contradicted the purposes of the corporation - maximising shareholder return. The Court
ruled that Ford owed a duty to his shareholders and ordered him to pay a special dividend
(Fisch (2006)).
In the light of these cases, lawyers began to debate shareholder primacy as a company
objective. In a series of law review articles in the 1920s and 1930s, Adolf Berle proposed
treating corporate managers as trustees with fiduciary obligations to act for the benefit of
shareholders. Berle's motivation, interestingly, was in having a corporate governance model
that redistributed power away from managers and towards "the people".
Together with economist Gardiner Means, Berle published in 1932 The Modern Corporation
and Private Property (Berle and Means (1932)). It argued that the ever-wider dispersion of
shareholders risked entrenching the power of management, creating "ownerless
corporations". Around the same time, Joseph Schumpeter warned that corporations could
become increasingly bureaucratic and run for their own ends, hampering the dynamism of
capitalism (Schumpeter (1942)). The solution proposed by Berle and Means was to give
shareholders primacy in a company's objectives, together with the control rights necessary to
meet this objective.
In the 1960s, Henry Manne started to weave Berle's legal perspective into economics
(Manne (1965)). He argued that shareholder primacy acted as a disciplining device on
management. Inefficient management would be reflected in a lower share price, making the
company an attractive target for a more efficient competitor. In other words, it was possible to
create a market in corporate control which could drive out company inefficiencies.
The shareholder-centric model also appeared efficient from a risk allocation perspective. If
control rights were placed in the hands of the party shouldering greatest risk - shareholders
- this provided the strongest possible incentives to safeguard the fortunes of the company.
The shareholder-centric model appeared to be a recipe for higher economic returns at the
lowest possible risk. This was an awe-inspiring combination. By the 1980s, corporate
success and the level of share prices had, in effect, become synonyms.13
Corporate governance today
The UK Companies Act 2006 can, in some respects, be seen as a natural evolution of this
historical trajectory. It arose out of the work of The Company Law Review Steering Group,
appointed by the government in 1998.14 Two fundamental issues arose. First, should the law
expect companies to consider responsibilities broader than shareholder maximisation? And
second, should the law attribute specific responsibilities to company directors?
It concluded that directors' duties should not be recast to include a wider set of stakeholders.
Giving directors pluralist duties risked turning "company directors from business decision
makers into moral, political or economic arbiters". In other words, shareholder primacy was
not just retained but now made legally explicit in Section 172 of the UK Companies Act
(2006):
"A director of a company must act in a way he considers, in good faith, would be
most likely to promote the success of the company for the benefit of its members
as a whole..."
The Group also suggested that directors' duties be defined in law. They were to serve the
interests of shareholders, first and foremost, but also had to "have regard" to wider interests,
including employees, customers, suppliers and the wider community. This "enlightened
shareholder value" objective was to be supported by public accountability, with annual
reporting on how companies were meeting their wider interests.15
The findings of the review were drafted into legislation, with the Company Law Act of 2006.
Under it, shareholders were given new legal rights to initiate proceedings against directors if
they breached their responsibilities. And the precise role of the "have regards" provisions
was left open to interpretation. Meanwhile, for the first time in history, shareholder primacy
had been hard-wired into companies' statutory purposes.
The microeconomics of companies
Given this corporate structure, what incentive problems might arise among stakeholders? It
is worth noting up front that the existence of these frictions is not, in of itself, a criticism of the
current corporate model. All corporate governance models embody these frictions to some
degree. A set of fully state-contingent contracts among all stakeholders could eliminate them.
But this first-best is infeasible (Hart (1995)). So the aim of any corporate governance model
is to minimise these frictions, rather than eliminate them, in a second-best or worse world.
In identifying incentive frictions within a company, it is useful to consider three distinct sets of
stakeholder relationships:
• First, between shareholders and managers.
• Second, between shareholders/managers and other company stakeholders
(bondholders, depositors, borrowers and employees).
• Third, between the firm's internal stakeholders and external stakeholders
(regulators, government and wider society).
Shareholders and managers
In a modern public company, shareholders and managers are distinct and serve distinct
roles. This separation has a micro-economic rationale. From Fama and Jensen (1983), it
generates gains from specialisation, with risk/return monitoring undertaken by the board of
Directors (acting on behalf of shareholders) and risk/return decision-making by management.
The micro-economic question is at what cost this separation is achieved.
(a) Classic principal/agent problems
Following the work of Jensen and Meckling (1976), the most extensively studied cost of
separation arises when management pursues their own private interests at the expense of
shareholders: for example, through corporate perks such as private jets or sponsored football
teams, empire-building such as value-destroying acquisitions, or rent extraction through
excessive executive remuneration. This is a classic principal/agent problem.
Those theoretical concerns gained practical prominence during the 1970s. The response
then was, on the face of it, ingenious: to align shareholder and managerial incentives,
remuneration contracts for management needed simply to be linked to shareholder returns.
This could be achieved by paying managers not in cash but in equity or in equity-linked
instruments, such as stock options.
And so it came to pass. Between 1980 and 1994, the average value of stock options granted
to CEOs of large US companies rose by almost 700%, while salaries and bonuses rose by
less than 100% (Hall and Liebman (1998)). The proportion of companies remunerating their
CEOs in stock more than doubled.
Those trends have continued apace in the two decades since. In 1994, US CEO
compensation was split roughly one third salary, one third bonus and one third stock and
stock options. By 2006, the dawn of the crisis, that split was less than 20% salary, less than
30% bonus and more than half stock and stock options. Among banks, the latter fraction was
higher still.
Whether this shift in compensation practices put a lid on CEO rent-seeking seems altogether
more questionable. Experience in the run-up to the crisis suggests, if anything, the opposite.
Paying in equity appears to have increased the probability of failure. Among US bank CEOs
pre-crisis, the top five equity stakes were held by Dick Fuld (Lehman Brothers), Jimmy
Cayne (Bear Stearns), Stan O'Neill (Merrill Lynch), John Mack (Morgan Stanley) and Angelo
Mozilo (Countrywide). This is not a random sample.16 It also suggests the macro-economic
costs of this principal/agent problem may have been non-trivial.
(b) Collective action problems: the "ownerless corporation"
A second stakeholder friction arises because a diffuse and dispersed set of shareholders are
likely to find it difficult to corral management (Shleifer and Vishny (1986)). There is a
coordination problem among shareholders. Moreover, most individual shareholders tend to
have modest amounts of skin in the game. This reduces their incentives to exercise
corporate control in the first place.
This shareholder collective action problem is not new. It lay at the heart of Berle and Mean's
concern about "ownerless corporations" in the 1930s. But there are good reasons for
believing this problem may have become more acute since then, as the shareholder base
has become more fragmented and diffuse and shareholder co-ordination more difficult (Kay
(2012)).
One reason is that the role of institutional investors has changed. They have tended
historically to play an important stewardship role. But this role has waned. As recently as
1990, pension funds and insurance companies held more than half of UK equities. Today,
that fraction is less than 15%.
There has also been a sharp fall in the fraction of shares held directly by individuals, from
more than 50% in the 1960s to little more than 10% today. Today, these individual holdings
tend to be indirect, operating through investment intermediaries of various types. That means
the beneficial owners of shares - individuals - tend to have little direct communication with,
involvement in, or indeed knowledge of, the firms in which they are investing.
One consequence of a more dispersed and disinterested ownership structure is that it
becomes harder to exert influence over management, increasing the risk of sub-optimal
decision-making.17 There is some empirical support for this hypothesis. For example,
companies tend to have higher valuations when institutional shareholders are a large share
of cashflow, perhaps reflecting their stewardship role in protecting the firm from excessive
risk-taking (La Porta et al (2002), Claessens et al (2002)).
(c) Short-termism
A third friction in the manager/shareholder relationship, distinct but related, arises when
different classes of shareholder have different rates of time preference. In particular, there
have been concerns about the rising share of investors with excessively high discount rates
and low holding periods - in other words, about "short-termism" (Kay (2012)).
There is clear evidence of the investor scales having rebalanced in this direction over time.
Average holding periods of shares have been in secular decline in a large number of
countries for a number of decades (Chart 1). In the UK and US, they have fallen from around
6 years in 1950 to less than 6 months today.18
Another diagnostic on short-termism is found by looking at company pay-out behaviour.
Chart 2 compares dividend pay-out behaviour among companies during two eras - the
mid19th
century period before shareholder primacy took hold, and the period since 1980 when it
has been uppermost in the minds of management (Haldane (2010)).
In the earlier period, dividends decreased as often as they increased. This is as we would
expect if profits fluctuate both up and down. After 1980, however, we see a one-way street.
Dividend payout ratios almost never fall. This is evidence that the short-term quest for
smoothing shareholder returns has come to dominate payout behaviour, almost irrespective
of profitability.
Another way to remit profits to shareholders is through share buybacks. These, too, have
risen in prominence. Among UK companies, share buybacks have consistently exceeded
share issuance over the past decade, albeit to a lesser degree more recently (Chart 3). In
other words, over the past decade the equity market no longer appears to have been a
source of net new financing to the UK corporate sector.
These patterns are, if anything, even more acute among US companies. Total buybacks by
US S&P 500 companies totalled over $500 billion in 2014, taking them back to their peak
levels in 2007. Total payouts to shareholders, both dividends and buy-backs, are also back
to their pre-crisis peaks, totalling almost $1 trillion in the US, and £100 billion in the UK, in
2014 (Chart 4). More generally, total payouts by companies have been on a steadily rising
trend since the 1970s, from around 10% of total internal cashflow in 1970 to around 60%
today (Chart 5).
The macro-economic consequences of this behaviour are likely to be far from benign. The
other side of the coin to high pay-out ratios from internal funds is low investment. There is
both direct and indirect evidence of investment having been adversely affected by
shorttermism on the part of either investors or managers or both.
The indirect evidence comes from looking at the discount rates used in, for example, equity
markets to assess investment projects. My own work has found evidence that these discount
rates appear to be around 5-10% higher than would rationally be expected at the one year
horizon (Davies and Haldane (2011)). And while that may sound modest, accumulated and
compounded that would act as a significant barrier to longer-horizon investment projects.
Moreover, this "excess" discounting has increased over time.
Evidence on companies' investment behaviour supports that conclusion - for example, by
looking at the investment choices of two otherwise-identical firms, one of which is publically
listed, the other private-owned. Studies in the US have found evidence otherwise-identical
private companies consistently invest considerably more, for given profits, than public
companies (Asker et al (2014)).
Chart 6 shows some diagnostics for a matched sample of public and private UK companies
(Davies et al (2014)). In line with US evidence, it suggests that investment is consistently and
significantly higher among private than public companies with otherwise identical
characteristics, relative to profits or turnover. In other words, shareholder short-termism may
have had material costs for the economy, as well as for individual companies, by
constraining investment.
Shareholders/managers and other stakeholders
(a) Risk-shifting
A fourth incentive friction arises in the relationship between shareholders and creditors in a
company. From the work of Robert Merton, under limited liability the equity of a company can
be valued as a call option on its assets, with a strike price equal to the value of its liabilities
(Merton (1974)).
The value of this option is enhanced by increases in the volatility of asset returns. Why?
Because, under limited liability, this increases the upside return to shareholders, without
affecting their downside risk. So for a firm seeking to maximise shareholder value, an
expedient way of doing so is simply to increase the volatility of company profits.
This risk does not, however, disappear into the ether. Instead it is shifted onto other
stakeholders in the company, most obviously creditors. There is, in the words of Jensen and
Meckling (1976), an incentive for the management of a limited liability company to engage in
"risk shifting" from shareholders to debtors, by increasing company-specific risk.
The scale of these incentives will depend importantly on how alert creditors are to this risk. If
they are wide-awake and price that risk by charging the firm a higher interest rate in
anticipation of risk-shifting, this serves as a disciplining device on management. Risk shifting
will then be stymied. However, if creditors lack the information or incentives to monitor risk,
risk-shifting will be amplified given the cheap costs of borrowing. The upshot, then, will be
companies engaging in a sub-optimally high amount of risk-taking from a stakeholder, if not
shareholder, perspective.
Banks provide an interesting case study of these incentive dynamics in practice and their
adverse implications for creditors and the wider economy. They have a particularly simple
way of increasing the volatility of their asset returns - increasing leverage. They may also
have stronger incentives to do so if their creditors - largely depositors - are de-sensitised to
risk when setting their cost of borrowing (Haldane (2012)).
If so, this is a recipe for super-charged risk-shifting - and was in the run-up to the crisis.
Leverage among global banks rose at real pace in the pre-crisis period, in a quest for
everhigher ban