Thursday, May 21, 2009

Is There an Agency Problem?

Is there an Agency Problem?

I want to call to your attention, as we turn from crisis management to building more viable global institutions of financial intermediation, a sophisticated cynicism that opposes more resolute commitment to business ethics and corporate social responsibility.

I am not referring to the common mistrust of private enterprise on the grounds that working for personal profit is inconsistent with securing a greater good for society. This is the perennial tension posed by philosophers and religious leaders between the claims of virtue and the attractions of self-interest. Rather, I am referring to a more academically polished elaboration of that argument which is called “the agency problem.”

Briefly put, the “agency problem” is said to be an inherent dysfunction in all principal/agent relationships, a dysfunction so powerful that such relationships can never fully achieve their stated objectives.

The “agency problem” exists on the agent side of the relationship: agents can’t be trusted to be diligent or faithful. They are always out for themselves and are constitutionally unable to put loyalty and service to their principals above their self-interest.

Thus, any business structure that relies on agency will always be a substantial risk to a principal, putting principals on their guard and forcing them to use tactics of fear and greed to keep their agents responsible.

The problem with this approach, however, is that the remedy feeds the disease.

Using self-interest to overcome self-interest has its limitations.

As long as we believe that the “agency problem” exists and is insurmountable, we have placed before us a conceptual roadblock to corporate social responsibility. Business is no more than a complex network of principal/agent relationships. Owners of corporations are principals to the boards of directors who manage them; senior company officers are agents of the boards and the companies; all employees are agents of their employers; banks, insurance agents, accountants, investment managers, lawyers are all agents to some degree for others. If the “agency problem” exists, then every relationship in this network is infected with the risks of negligence and betrayal. Social Darwinism or dog-eat-dog would seem to be the only rational approach to a life in business. It would be foolish or worse to expect such an environment to ever promote responsibility to the common good.

Advocates of corporate social responsibility must presume something other that the “agency problem” as an immutable fact of business life. Corporate social responsibility, corporate philanthropy, corporate citizenship, all ask of business and business decision-makers a showing of responsibility to others. Usually the responsibility of business is stated as having respect for the interests of stakeholders: customers, employees, owners, creditors, suppliers, competitors, and communities, including the environment.

The problem of faithless agents

If we want a more moral capitalism, we have to solve the “agency problem” or, at a minimum contain its virulence. Modern capitalism generates wealth through specialization of function and division of labor. This fact was Adam Smith’s great insight into the origin of the ‘wealth of nations” as he called it. But, as labor is more and more specialized, each component sub-unit of the economic system becomes more and more dependent on all the other parts. In today’s world of high technology, dependency on specialized machines and the skills of professional experts is higher than ever in human history. Our modern world is also completely subservient to reliable flows of electricity.

The Turkish Airlines plane that recently crashed short of the runway at Schiphol Airport outside of Amsterdam did so because its altimeter was faulty. Nine people died as a consequence of the pilots’ relying on a mechanical device for guidance in landing.

If the “agency problem” is all powerful and all pervasive, then modern capitalism is constant at risk of failure because the dependency relationships that flow from specialization are prone to abuse on the part of those who dishonor the reliance and trust placed on their competence and their integrity.

A market place of lying sellers and conniving buyers will never grow very prosperous. When faith and trust evaporate, so does capitalist wealth. The current meltdown of global financial markets is a good case in point.

But, the seriousness of the “agency problem” has been overstated. If it were truly dominant in the business world, modern capitalism with all its relationships of interdependency and mutual benefits would not have emerged to produce the wealth that we enjoy today – even in these months of a serious global recession. Thus, we can infer that there are some countervailing forces that nibble away at the “agency problem”.

What can we do about faithless or negligent agents?

The problem is not a new one. In the Judeo-Christian tradition, the prophet Samuel warned the leaders of tribes of Israel not to put their faith in kings, for, as he predicted, kings would turn against their trust and abuse power for their own selfish advantage. Later, Jesus stated that one could not serve both God and Mammon.

The Common Law of England over the centuries fashioned many legal responses to minimize the effects of the “agency problem”. These rules and practices constitute what is called the law of fiduciary duties. Also, the English courts of Equity contributed to fiduciary law with their own set of procedures and requirements designed to remedy abuse of legal power and prevent fraud and oppression in the marketplace.

The basic device used by the Common Law to minimize the effects of the “agency problem” was to define what was expected from agents as duties to their principals and give principals specific remedies for breach of those duties. This was a practical approach that sought to structure incentives so that agents would be more inclined to stick to the punctilio of their responsibilities and principals would be induced to assume the risk of trusting agents. Other words used in the Common Law to resolve the agency problem were fiduciary, trust, and beneficiary of the fiduciary trust. The fiduciary or the keeper of the trust was, in effect, the agent and the beneficiary was, in effect, the principal.

First, the agent was burdened with duties of loyalty and due care. When the self-interest of the agent was suspected of causing harm to the principal, the burden of proving loyalty was placed on the agent. The agent had the burden of coming forward with sufficient evidence to prove his or her loyalty. With respect to negligence on the part of the agent, the principal had the burden of proof but could hold the agent accountable when an objective standard of care had not been observed in management of the business consigned to the agent.

The Common Law thus turned the relationship of principal/agent into a status for the agent. Agency was an office; so was being a partner, a trustee, a corporate director, etc. With office came specific responsibilities. Failure of performance was transformed from a difference of opinion between agent and principal into a notorious setting of public expectations. The behavioral theory used by the Common Law judges appears to be a conviction that when we are made accountable in public, our pride tends to keep us more scrupulous and diligent than when we can act in secret. Principals could deny their own liability for acts of the agent when the agent had acted contrary to the terms of the trust, leaving the agent exposed to face the consequences.

Exposure and transparency were devices used to reduce agency problems.

Second, in its courts of Equity, English jurisprudence fashioned a number of rules that principals and beneficiaries could use. They could seek an accounting of monies had and received, with the burden on the agent to account for every penny received; principals could ask for the imposition of a constructive trust on money and property in the agent’s possession and name when fraud and abuse had occurred; agents had to have acted with clean hands if they sought to recover from principals on their agency contracts; agents could be prevented (estopped) from entering claims and evidence in their favor if they had acted inequitably.

Use of self interest

A second basket of remedial responses to the “agency problem” lies in self-interest. It is in one’s best interest to avoid faithless agents. Over time, therefore, faithless agents will not find employment as their reputation for negligence or disloyalty becomes generally known. This is why reference checks are so frequently relied upon. Generally, market based solutions to the “agency problem” rely on this mechanism of self-help. But it can be of limited utility where agents or those upon whom we rely for professional expertise have market power or are polished performers adept in the arts of lulling our suspicions with their smoke and mirrors – like Bernie Madoff to his investors.

Use of character

The third approach to minimizing the “agency problem” is to promote good character, the habits of living up to the virtues of trustworthiness, integrity, diligence, transparency and reliability. This agenda for securing better prospects for corporate social responsibility and business ethics – for avoiding asset bubbles and financial bubbles – and for putting in place the cultural foundation for specialization of function and division of labor operates at the level of the individual.

We must engage individuals to act as we would want if we want responsible and faithful agents. Such socialization, obviously, begins in the family, continues in school, and is finished in conditions of social engagement. We are concerned for the “presentation of self” in everyday life and Irving Goffman wrote about our dysfunctions in organizational settings. We want a good self to be presented, not a greedy, abusive, stupid or negligent one.

Having good character is one reliable ground for good stewardship behaviors. The moral sense within us is a public good in that it promotes trust in our communities and reliance on our business performance. Trust and reliance form the substructure of successful modern capitalism.

That human persons possess a moral sense that distinguishes them from beasts and other earthly creatures is increasingly a postulate of evolutionary studies, neuro-science, and brain research.

Thus, we must not presume that the “agency problem” is intractable and a permanent obstacle to responsible business decision-making. Rather, we should assume in us all an inherent capacity for reliable agency performance.

Set the bar high and we will tend to jump higher; set it low and we will slack off and get away with poor performance.

social capital and Wall Street

Social Capital and Wall Street

Stephen B. Young
Caux Round Table Global Executive Director
April 2009

A very important thesis about the dynamics of capitalism creating the wealth of nations holds that necessary cultural preconditions shape the scope and intensity of capitalist success. Where these preconditions are in effect, wealth is created; where they are missing, wealth is, relatively speaking, scarce.

The social nature of capitalism as a system, its manipulation of multiple interdependencies arising from specialization of function and the division of labor, demands an appropriate cultural context. Some values as carried into market and investment behaviors promote robust capitalism; other values don’t.

This observation honors the seminal insights of Max Weber, who a century ago, identified the rise of capitalism as an economic system new and unique in human history, with the social arrangements legitimated and encouraged by Calvinist religious beliefs. Weber argued that a peculiar set of values flowing from Calvinist convictions that individual salvation depended upon diligent and faithful application of one’s talents to the calling that God had provided here on earth. Frugality, discipline, confidence in the future, trust in others of the same faith, stepping up to personal responsibility in one’s relationship with God, and similar Puritan behaviors, thought Weber, all contributed to opportunities for investment in enterprise, reliable contracts and high savings rates to create financial capital available for investment.

While many have questioned Weber’s attempt to link particular aspects of Calvinist beliefs and practices to the capitalism that emerged in 16th century Holland and 17th century England, Scotland and British colonies in North America, few can deny the coincidence of capitalism’s first emergence in those Calvinist societies.

Now, if recent practices on Wall Street associated with sub-prime mortgages, mortgage backed securities, CDOs and CDSs have produced a loss in 2008 of some US$50 trillion in asset values, one would have to question how successful such a capitalism was in creating new wealth.

More than such losses, some of which will be restored as markets recover from the collapse, the market collapse caused the collapse of Bear Stearns and Lehman Brothers and the conversion of the remaining investment banks into more traditional depository institutions. The American government, through its Treasury and Federal Reserve system, assumed many trillions of dollars of financial obligations to keep the banking, credit and financial intermediation markets operating. At one point, the Federal Reserve was purchasing the commercial paper of American companies due to failure of the private market for such debt. This was an unprecedented failure of private sector decision making.

The outcomes of Wall Street’s marketing of these financial instruments were not beneficial for anyone and such marketing could not be sustained. This episode of financial intermediation was a failure from every point of view once “irrational exuberance” took over the markets. It should not be considered genuine capitalism but only speculation over the value of present contract rights to future income.

If the connection between cultural habits of mind and action and successful capitalism is to hold true, it must be that Wall Street lost some of its social capital as a prelude to this most recent round of irrational asset valuations.

The corollary argument to Weber’s thesis on a smaller scale appropriate to these financial market transactions would be that the kind of social capital needed for capitalist achievement was missing. And, moreover, that loss of social capital caused, or at least contributed to, the collapse of asset values in the crash of 2008.

If the thesis is to hold that loss of social capital correlates with the loss of wealth as the inverse of the proposition that accumulation of the same social capital leads to wealth creation, where was the erosion of social capital on Wall Street prior to the financial collapse of trading markets for sub-prime mortgages, CDOs and CDSs and the resulting collapse of global credit markets?

Let us consider first a generic model of the social capital relevant to capitalist wealth creation.

There are of course innumerable varieties of social capital, each with different modalities of values and behaviors and each promoting different outcomes. The social capital that supported Egyptian Pharaohs and supported their construction of pyramids and temples was most likely different from the social capital that sustained Native American tribes in their pueblos, teepees and long houses.

The virtuous behaviors that Weber marked as sponsoring capitalist endeavors flowed from a social capital value set that had certain special characteristics.

This social capital supported longer time horizons for instrumental economic engagements. Investment more than trading was brought to the fore of business thinking. Expectations of rewards were stable and realistic. People were patient and delayed gratification in order to save and invest. Such people worked at their trades in a reliable fashion so that they became good credit risks and trustworthy stewards of moneys invested in their undertakings. Their work was their bond. There were clear laws and just enforcement so that promises and contracts were worth something as predictions of future events. Having a reliance interest in the success of others was justified. Financial intermediation was enhanced; money capital could be accumulated for use in joint enterprises.

All these reliable behaviors lowered risks and so interest rates and promoted transactions. Investment of time and money in production and delivery of goods and services with substance, with the power to leverage production of more and better goods and services and meet new needs was intuitively desirable. The future would be better and a commitment to progress today would realize that future tomorrow.

Next, this social capital placed a priority on learning, education and the introduction of new mechanics and technologies. It was comfortable with secular approaches and did not disdain the material world of chemistry, physics and biology.

People growing up in such conditions will be more thoughtful about the consequences of their actions on others. Externalities are brought home to the actor through an ethic of pride in one’s work and in one’s contribution to community.

Now, the opposite of these behaviors and commitments, we can infer, would most like not lead to wealth creation.

Social patterns where people focus on the immediate and will not commit now to benefits to be received much later, where they have no patience and do not trust the word and reliability of others, will promote higher levels of risk and so higher expectations of interest on money lent and returns on equity funds invested. There will be fewer transaction of substantive investment. The cost of business will be much higher. Savings will be rejected in favor of current consumption. People will seek cash money to use its power over those who are perceived to be and, in fact, are not trustworthy or reliable. Stewardship responsibilities will go begging for honest fiduciaries to accept them.

As there are lower standards of responsibility accepted, there will be lower standards of care in general and higher transaction costs in third party engagements as a result. Risks will be pushed off on others as much as possible.

Starting in 1980, Americans in general moved from a high savings culture to a high debt culture as the Baby Boomers came into full maturity and cultural leadership. New norms and behaviors came to the fore in many parts of American society. Assuming responsibility in civil society organizations, in politics, in anything outside one’s family, circle of friends or professional tasks linked to renumeration occurred less and less. Robert Putnam noted this trend in his seminal book Bowling Alone. Even in family life, parental responsibilities were sloughed off. Divorce became very common and schools were looked upon as the primary means of socializing the children. Seniors were encouraged to live out their last years on their own in retirement homes and facilities.
Wall Street and its practices were not immune from this cultural evolution.

As a result, the social capital embraced and accumulated by Wall Street shifted in its nature and its proclivities. For example, time horizons became shorter. Short term thinking became the norm. People lost loyalty to employers as they kept on constant lookout for new jobs with higher pay. Legal formalities replaced a personal standard of care for the well-being of clients and customers. Using debt to fund consumption and more pleasurable life styles demonstrated the power of short-termism among Americans. Delayed gratification was disparaged by Baby Boomers.

People looked more and more for higher short term returns. Few invested equity in companies for the long haul, preferring to profit from “renting stocks” rather than owning them and realize long-term capital appreciation from the company’s profits and retained earnings. Leverage became king so that higher returns could be enjoyed through the short-term use of other people’s money. The banking system converted from well-capitalized institutions that held risk to maturity to ones that merely traded risks back and forth for fees and spreads.

Investment banks went public and so lost the long-term perspective and caution that goes with partnership structures where the personal assets of the owners were always at stake in the risk level associated with firm activity. Professional mangers took over from owners as the drivers of firm strategies. Trading desks grew more powerful within the investment banks as their trading profits came to dominate firm income and the culture of traders took over from the older, more white-shoe culture of cultivating long term client loyalties and connections.

Personal responsibility for investment decisions was replaced with reliance on portfolio theory and mathematical algorithms. The Black-Scholes formula for calculating value when no market for a contract claim existed and the “chasing” of Alpha returns by institutional money managers were the most famous examples of this new intellectual environment on Wall Street. Companies were judged for better or worse on whether they “made the numbers” predicted by professional estimators. Trust in a company’s leadership was replaced with a more mechanical formulation of what constituted success.

The chase for higher returns – more fees and commissions – correlated with a decline in general levels of trust and commitment. Fund managers knew that to take risks and not earn returns within a peer group average would lead to the loss of money under management. Herd thinking was acceptable as it was “normative”.

Executive compensation was more and more linked to short term results, especially at senior levels where strategic commitments were made and cultural norms were adopted within firms for replication at lower levels of corporate hierarchies. Money results, not fiduciary quality, drove the decisions of many CEOs in all industries, not just Jack Welsh at General Electric.

While newer values promoted these structural changes in business models and practices, the new power arrangements solidified the intensity with which the new values could drive individual decisions and manipulate individual life choices in set ways.

Wall Street became captive to playing with other people’s money on a gigantic scale. Savings and reserves in exporting countries like China and the funds accumulating in pension funds, sovereign wealth funds, and hedge funds was there for the taking, or rather, the borrowing. Access to funds came through the sale of instruments that promised high returns.

Debt and short-term investing – largely tradable instruments to boot - took over from traditional equity as the criterion for financing capitalism; leverage ratios of banks and investment banks went to historic highs; structured financial instruments – mortgage backed securities and CDOs – were produced to fit new market demands for using short term leverage and trading in contract rights. CDSs were invented to provide risk reduction in lieu of tradition equity and capital reserves. Sadly, since many CDSs were only backed by legal documentation and not real money, the risk reduction they provided was illusory. It was use of pledges that had no reliable commitment behind them to give them “credit”. The words on a CDS, and on many CDOs, did not reflect that firm’s bond. Counterparty risk eventually caused the credit system to freeze and so become useless. Mathematics and formalisms drove trading in financial instruments.

An asset bubble was thus easily assembled by Wall Street firms and experts.

Any asset bubble is destined for collapse as financial wealth is destroyed and real economic activity retreats.

The factors that grow asset bubbles are inimical to the growth of genuine capitalism that produces the “wealth of nations”. When Wall Street produces such financial houses of cards, it only reflects social capital values and structures that are not supportive of good capitalism.

To improve the outcomes of financial intermediation, then, the social capital formation of financial centers like Wall Street needs scrutiny and attention.

If we want to restore robust creation of real wealth which can be enjoyed for many years and which can lead to creation of further wealth on the part of others – workers and investors alike, then we must - as the first item of such business - look to the values embodied in our financial firms.