Category: Personal responsibility

It takes a village to maintain a dangerous financial system – and a corporate governance system too

Hillary Clinton popularised the African proverb “It takes a village to raise a child” when she adopted it as the title for her 1996 book. A lawyer representing victims of abuse by Catholic priests in Boston extended when interviewed in 2015 by observing that “If it takes a village to raise a child, it takes a village to abuse a child.” Anat Admati, George G.C. Parker Professor of Finance and Economics at the Graduate School of Business at Stanford University, translates this sentiment to the financial sector in her in chapter in Just Financial Markets? Finance in a Just Society, a collection of essays edited by Lisa Herzog, published by Oxford University Press[1].

Admati’s focus is on the banking system. Her thesis is that the failings in the system, illustrated by the 2008 crash, are a result of the failures of a wide range of players, not just those working within financial institutions, but a host of regulators, commentators and other stakeholders. Very powerfully, she comments on the contrast between the finance industry and other industries (eg aviation) where safety is paramount and all consequently all the stakeholders work together to design effective regulation and where the case for compliance is compelling. But, as she points out, even the most obvious case for regulation to drive safety may require disasters and egregious failures before regulation and compliance catch up with the need (eg in nuclear power and the motor industry).

Her chapter provides a compelling account of the “wilful blindness” of principals, stakeholders, regulators and commentators on the financial system and suggests that even after the dangers inherent in the design, operation and lack of necessary regulation of the banking system were revealed in the crisis, the underlying problems remain unaddressed.

Her arguments are applicable far more widely. She has written an important paper about that should be read with an eye to how her observations can be applied to other industries and, indeed, beyond the commercial enterprises into public sector organisations and not for profit bodies.

[1]Chapter 13, It Takes a Village to Maintain a Dangerous Financial System. Abstract: I discuss the motivations and actions (or inaction) of individuals in the financial system, governments, central banks, academia and the media that collectively contribute to the persistence of a dangerous and distorted financial system and inadequate, poorly designed regulations. Reassurances that regulators are doing their best to protect the public are false. The underlying problem is a powerful mix of distorted incentives, ignorance, confusion, and lack of accountability. Willful blindness seems to play a role in flawed claims by the system’s enablers that obscure reality and muddle the policy debate.

Paul Polman, CEO of Unilever, on sustainability, purpose and living by his values

In the late 1980s, the buying and merchandising team I led at high street retail chain WHSmith launched a substantial new range of environmentally responsible stationery. It resonated with the personal values of the team, in short we believed that it was the right thing to do. We also argued that it would be good for the company and provide us with an edge over competitors, since it would be attractive to a significant number of our customers, would help us with staff recruitment since we believed that smart young people wanted to work for an environmentally responsible company, and would help enhance the wider reputation of the company with marketing benefits spilling over into other product categories and win sympathy for us in other ways, even to the extent, for example, of creating a benign audience in local authority planning decisions.

This weekend’s FT contains a profile of Paul Polman, chief executive at Unilever for the past seven years, who has taken an even bolder and more extensive approach to environmental responsibility. His leadership reflects an explicitly understanding of the diversity of market dimensions and that companies need to consider, a sense of that the purpose of the company reflects long term sustainability – of the company and the environment in which it operates.

His responses to his FT interviewers speak for themselves:

“P&G started in 1837, Nestlé in 1857. These companies have been around for so long because they are in tune with society. They are very responsible companies, despite the challenges that they sometimes deal with, all the criticism they get”

When Polman became chief executive of Unilever …. he said that he only wanted investors who shared his view that Unilever needed to shepherd the Earth’s future as carefully as it did its own revenues and profits…..“Unilever has been around for 100-plus years. We want to be around for several hundred more years. So if you buy into this long-term value-creation model, which is equitable, which is shared, which is sustainable, then come and invest with us. If you don’t buy into this, I respect you as a human being but don’t put your money in our company.”

The FT article explains that Sustainable Living Plan adopted by Unilever has not met all its targets, pushing back the date for halving its products’ environmental impact from 2020 to 2030 but it has reduced the waste associated with the disposal of its products by 29 per cent, with the aim of hitting 50 per cent by 2020.  It is not without its critics, but a report from Oxfam report on the company’s practices in Vietnam identified “a number of critical challenges in translating the company’s policy commitments into practice”, the charity’s latest Behind the Brands ranking, which looks at the top 10 food companies’ record on small farmers, women’s rights, the use of land and water and greenhouse emissions, put Unilever in first place, ahead of other leading consumer products companies.

The outcome has been good for the company’s relationships with investors. In the FT’s words: “while he told short-term shareholders to shove off, he delivered good returns to those who stayed. Unilever’s total shareholder return during Polman’s tenure has been 203 per cent, ahead of his old employer Nestlé and well ahead of P&G………. The company has also succeeded in attracting more long-term shareholders………before Polman’s reign, 60 per cent of the company’s top 10 shareholders had been there for five years or more. Today, 70 per cent have held their shares for more than seven years.”

It is also clear from the FT article that Polman has also adopted this approach to environmental sustainability because of its alignment with his personal beliefs, and that his belief that the wider purpose of the company (which he likes to an NGO) is a further illustration of his own belief that he should live his personal values in his corporate career. The Saïd Business School’s Colin Mayer, author of The Firm Commitment, tells the FT “He has demonstrated immense courage and vision in promoting a concept of the purpose and function of business that initially met with considerable resistance, bordering on hostility, from several quarters.”

Failing the marshmallow test

The BBC World Service is the insomniac’s salvation. If you are lucky, a background of talk radio helps you back to sleep. If you are luckier still, you stumble on a piece of quality programming that Auntie has chosen to share with the rest of the globe but not with its domestic listeners.

“In the Balance”, a business programme presented by Andy Walker at 03:30 GMT on Sunday 2nd November, included a first class discussion of short termism between Bridget Rosewell, Geoffrey Franklin and Richard Dodds, following an interview with John Kay that marked the second anniversary of the publication of his report for HM Government on short termism in equity markets.¹

The essential conclusion of the Kay report [reference needed] was that there is too much short termism in UK corporate life at the expense of addressing long term competitive advantage. The top management of quoted companies focus unduly on hitting 3 monthly targets, which are a poor measure of management competence, and have been rewarded accordingly. The 1990s featured attempts to align management incentives with the interests of shareholders, but the net result was that “many people who were quite incompetent made quite a lot of money”. Kay concludes that regulation is not the solution, but that a change in culture is required, but that it is hard to know how to do this, and harder still to measure progress.

Kay expanded on the culture change required and the inherent difficulties. He referred to the “marshmallow test”, an experiment with 4 year old children. Most, when presented with a marshmallow and told that if they wait 5 minutes before eating it they will be given a second one, will eat it right away. (A celebrated study of children subjected to the marshmallow found that those who exhibited a lower personal discount rate and exercised sufficient self control to win the second marshmallow – or maybe just had the insight to understand the challenge facing them – prospered more in later life). Andy Walker asked John Kay whether he was saying that executives simply need to grow up, to which Kay responded “a lot of company directors would fail the marshmallow test.”

In the ensuing discussion among the panellists, Bridget Rosewell blamed her profession (economists) for promulgating the view that all the information about the future prospects of the company is captured in the share price, and consequently many board level remuneration packages have been structured around movements in the share price, and the panel as a whole seemed to conclude that we have spent years telling people to focus on the wrong thing. Further, Rosewell also observed that “All markets exist in institutional contexts and cultural contexts.”

Is John Kay right? Undoubtedly yes. But the supplementary questions are more interesting: why do so many fail the marshmallow test; and what can we do about it?

There are probably could be three underlying reasons for the behaviour Kay describes.

One is that, notwithstanding the experimental data that suggests that people who come out on top in later life are  those who as small  children passed the  marshmallow test, perhaps some of those who make it to the upper reaches of commercial organisations respond disproportionately to short term signals. (Or maybe, by the time that they have reached the upper reaches they are no longer capable or responding to anything other than short term signals?).  This is not something that I have observed myself, but there may be some revealing academic research lurking in the nether regions of a business school somewhere that addresses the personality types of chief executives and points to this failing.

A second explanation could be that human timeframes and organisational timeframes may be intrinsically misaligned. “In the long run, we are all dead.”  The career time horizon for a typical chief is only exceptionally longer than twenty years on first appointment.  Even then, the time horizon within the specific appointment is only exceptionally more than ten – and probably for very healthy reasons including personal boredom thresholds and the benefit from time to time for a fresh set of eyes on a problem.  Whether it is desirable is irrelevant, it is entirely reasonable for individuals to consider the rewards – both material and emotional – that will flow from what is deliverable and measurable within their own term of office. And although they may also be concerned for their own legacy in the role, they also have to reflect that they have little power to stop those who come after them frittering it away.

The final explanation relates to the institutional and cultural frameworks about which Kay and the “In the Balance” panellists agonised. The evidence here is compelling (although I would not go as far as Rosewell in condemning the argument that share prices capture all the information about a company – the point, for discussion in more depth elsewhere, is that the prices of traded financial instruments are corrupted because they also capture information about expectations about trader behaviour (in an economist’s version of Heisenberg’s Uncertainty Principle). Many management teams have been presented by academics, consultants, brokers, investment bankers, and journalists, arguably in error, that they must respond to and seek to affect short term share price performance, and the regulator environment has encouraged rather than discouraged this.  Given that the possibility that the first of these three explanations holds true for some executives, and the probability that the second of these three explanations holds true for most, it is all the more pernicious that the we have aligned cultural and institutional frameworks in this way. Instead, we need to bend over backwards to create a culture and institutional framework as a counterweight to the possibility that personal discount rates – driven by hardwired human appetites and instincts – are higher than those of companies and organisations in general, and society overall.

So, who’s eaten my marshmallow?

 

¹ The Kay Review of Equity Markets and Long Term Decision Making, July 2012