Friday, October 06, 2006

 

Corporate Scandals, Economic Crises, and the State

Karl Marx predicted that the successive economic crises, which are inherent to the capitalist system, would eventually lead to revolution and to the downfall of capitalism. Max Weber contradicted this view in a speech held in Vienna in July 1918. Not revolution, but increased regulation of economic activity – either through economic actors themselves or through state action – would be the consequence of economic crisis. Hence, each crisis would lead to an increase in economic organisation, i.e. to a development away from the original liberal (or savage) capitalism towards a regulated form of capitalism.

This latter view is highly relevant to the contemporary debate on corporate governance. In fact, an analogy can be made between economic crisis and corporate scandals. Of course one could object that a corporate scandal, involving only one company, cannot be compared to a full-scale economic crisis that can menace the wealth of an entire population. Right…but still, if we look at the size of modern companies, the analogy does not seem that far-fetched after all. Multinational companies (MNCs) have annual sales that exceed the GDP of not just some poor sub-Saharan states but of quite large European countries (e.g. the sales of Ford exceeded the GDP of the Czech Republic in 2005 by far). Hence, corporations have become enormous economic entities and the failure of such a company, one could argue, have an economic impact that can be compared to an economy crisis.

Be that as it may, Max Weber’s prediction has been supported by evidence from many crises and scandals throughout the 20th century. From the ‘Kreuger Crash’ triggered by the suicide of the Swedish ‘Match King’ Ivar Kreuger on March 12, 1932 in Paris, to the failures of Enron and WorldCom, corporate failures have often had as a consequence an increased activism by policy makers and major changes in the legal framework governing the economy. And there are certainly good reasons to do so. In fact, corporate failures and economic crises are bad for those involved, but good for people who are interested in understanding the functioning of the economy. In fact, crises and scandals reveal the functioning of the economy much better than any other economic phenomenon. They reveal loopholes in the existing legislation, and allow us to learn a great deal about economic practices that develop in between the lines of the legal text. This can be profitable to policy makers. In fact, policy making is of course much easier with the benefit of hindsight. So, why should the state not learn from past mistakes and integrate the new insights in new laws?

Well, many examples show that the scurried adoption of legislation subsequent to a scandal might not always lead to the best results. Take the Sarbanes-Oxley Act of 2002, which was adopted right after the Enron and WorldCom disasters when the gun was still smoking. Of course, this piece of legislation brought about some improvements notably concerning accounting rules. However it was adopted – under the pressure of the popular outrage – first and foremost in order to show that politicians are capable of effective crisis management. The result was a not so well thought-out law that introduced arguably unrealistic dispositions implying enormous costs for companies. The compliance costs with the SOA were especially for smaller companies completely out of scale so that the Securities and Exchange Commission (SEC) eventually proposed to exempt them from compliance at least with section 404 of the SOA (Report of management on internal control over financial reporting).

A similar precipitous law could be adopted in Switzerland in the near future following the Swissfirst scandal that I wrote about in an earlier posting on this blog. The alleged corruption scandal around the merger of Swissfirst and Bank am Bellevue, implying several pension funds, has opened a breach for all sorts of regulatory moods. Politicians agreed quickly on the source of the problem, i.e. the so called “parallel trading”, which designates the fact that the administrators of pension fund assets buy privately the same shares as they buy for their fund. In the online edition of the NZZ of October 4, 2006, one could read that politicians of all political orientations attacked this ‘new’ evil. The administrators of pension assets, so they argue, should be prohibited by law to trade with the same shares as they buy for the fund. One Social Democrat in the lower house described the ideal pension fund administrator as “a eunuch in a harem” (NZZ October 4, 2006)!

Such a rule may seem sensible at first glance. Especially if one thinks of another – minor – recent scandal that implied one of the investment companies belonging to Bank am Bellevue, BB Medtec. This investment company published, in August 2006, a report for its customers recommending buying shares of Nobel Biocare. At the same time, BB Medtech had reduced its own stake in Nobel Biocare from 10.2% in December 2005 to 9.6% in June 2006. It probably even further reduced that stake after that date since BB Medtech refuses to disclose its current stake in that company (NZZ, September 24, 2006). This kind of behaviour is of course unacceptable. Yet, what the Swiss Parliament is actually aiming at are – consciously or unconsciously – not such very problematic contradictions between one’s own trading strategy and recommendations to ones costumers. The discussions turned explicitely around parallel trading, which does of course not do any harm to whosoever. In fact, prohibiting these kinds of activities would even contradict a central principal of good corporate governance as it is advocated by many corporate governance specialists, i.e. the fact that the management of a company should hold stock (or stock options) of the company they manage. This permits to link the managers personal wealth to the company’s success, creating thus necessary incentives. Similarly, a pension fund administrators who buy the shares they also buy for their fund is a sign of the conviction that the fund’s investment strategy is a good strategy and will potentially make administrators more attentive to the evolution of these shares.

Hence, ‘parallel trading’ is clearly not the most urgent problem – if it is a problem in the first place – that the legislator should tackle. In fact, Here, policy makers propose – under the pressure of public opinion and because an opportunity window for new regulation was opened by the scandal – to regulate a question, which is not even remotely responsible for the actual scandal. The question is if politicians are aware of the fact that they are off the mark concerning this question, but just don’t care, or if this the result of overhasty policy making. Be that as it may, rather than firing a snapshot in the heat of the battle, what the Swiss Parliament should do in this situation is continue the reform of pension fund surveillance that was commenced by the Federal Government before the Swissfirst scandal. Maybe for once the proverbial slowness of the Swiss decision making process can have a positive effect in the sense that in a couple of weeks factual and dispassionate problem-solving could be possible again …


Comments:
I wonder if a parallel could be made between what you just wrote in this post and what risk management has to say regarding catastrophic events. I am refering to Heimann's work, or the work of Landau in the 1960s. Both proposed to describe the dynamics of regulation according both to context and perverse effects: after a catastrophe, regulators will modify legislation to make sure that security (widely understood) is not ignored in favor of business interests; the trouble is, this sort of regulation might do a lot of harm to private interests , especially if controlers make wrong, exaggerated assessments of the risks involved; later on, the context will change, and the priority will be to favor business again, which would mean an opposite trend in the legislation; but then the risks of another catastrophe will be much less well managed... and so on. That kind of cycle was evidenced by Heimann in his study of NASA. But maybe you could apply the same reasoning to your field? For instance, the regulation of banking was severely modified in the USA after the 1929 crisis, but I heard it's been modified again a few years ago, authorizing the creation of very large banks while it had been severely controlled before. What do you think? The metaphor of a cycle seems more convincing to me than the weberian one of ever-increasing regulation...
Best
julien
 
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Julien,

Very interesting point you're making indeed! Maybe I’m too much influenced by the ubiquitous complaints by liberal economists, politicians but also by normal citizens that our actions are more and more constraint by laws and regulations...

The US banking law you’re referring to was the Glass-Steagall Act (GSA) of 1933, which prohibited banks to be active at the same time in commercial and investment banking (see http://www.investopedia.com/articles/03/071603.asp). This law put thus a term to the universal bank system as we know it notably from Germany and Switzerland. It was indeed a reaction to the 1929 stock market crash and the following failures in the banking sector. The GSA was finally abolished in 1999.

I think one could find other examples for a cyclical regulation and deregulation processes. But I still have the feeling that even when regulations are abandoned, this happens in a ‘regulated way’ (the social scientist Steven K. Vogel talks of “freer markets, more rules” ). This may sound paradoxical, but if you think of capital markets for instance: in many countries restriction on capital movements and on different financial instruments have been considerably weakened. However, there is always some kind of "shadow of the state"; some save-guards. The risk-aversion of our contemporary societies, it seems to me, makes that just abolishing rules is not acceptable; deregulation happens in a controlled way.
Of course, there are phenomena, which just were not taken into account by regulators, either because they were not considered to be important, or because they simply didn't exist at the time the regulations were established. Think for instance of the hedge fund industry were regulations in most countries still are very embryonic, or even inexistent. To be sure, once a major scandal involving hedge funds will occur, new regulations will follow. A first hint at this can be seen in the crisis of Amaranth - a US hedge fund - that lost about half its value ($ 5b) in two weeks this September. This will certainly spur the claim for increasing regulation. (A first attempt by the SEC to regulate the hedge fund industry was made in 2004. However, this decision was overruled by an appeal court shortly after) (NZZ, September 19, 2006).
It may very well be that such a new regulation will - because of the impact of the crisis on public opinion - go rather far. But then eventually, once the scandal is a thing of the past and public opinion starts to worry about other things, the interested actors’ claims for a weakening of the law might be heard by politicians and steps could be taken to attenuate the measures. I think that's about what is happening with the SOA and it’s a plausible story in general. But of course, one should think about the cyclical nature of scandals and regulations more systematically!

The major problem however with assessing if there are cycles of regulation and deregulation or not may be linked to the length of these cycles. The example of the GSA that you mentioned for instance shows that they can be rather long. In fact, 60 years passed between the coming into force of the law – followed by a phase of rather increased regulation – and its eventual abolition.
At a very macro-level one could identify the following phases: a first phase of unregulated modern capitalism during the 19th century (what is usually called the “founding years”); an increasing role of the state in regulating the economy starting in the late 19th, early 20th century and lasting most of the 20th century; and finally the liberalisation and deregulation frenzy starting in the 1980s. With one phase lasting for 80 or so years, it might be that we just don’t have enough historical distance in order to really judge if it’s a story of cycles or just of ups and downs that do not reveal any systematic pattern. Or, maybe if we look at different industries particular, such phases of regulation and the regulation would appear to be shorter? Anyway, very interesting questions…


Best,
Gerhard
 
Well you sure is right about that deregulation/re-regulation thing. And the idea of seeing cycles there is indeed both tempting and daunting. The example I gave, which you made much more precise than I could, is too short to support the idea of regulatory cycles, I agree. However, leaving the issue of measuring cycles out, I guess it is probably better to think in terms of "more and less resources" for certain goals rather than in terms of "more and less rules". We know that public authorities rarely suppress rules, and that a lot of rules end up dead only because resources to implement them got cut…
Anyway, the issue of perverse effects of a legislation, which you raised in your post, could be yet pushed a little bit further by taking this kind of legislation as a form of risk management, or say, meta-risk management, as Grabosky calls it. That is, firms invest in the management of their own risks, and public authorities make sure they do this well by giving them a more or less constraining framework to follow. By so doing, they are a part of the risk management. Now, if you put it this way, it is in no way certain that self-regulation of risk management would not produce its own internal perverse effects (which public legislation could counterbalance), just as public legislation could produce perverse effects in its own right...
Best,
Julien
 
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