Alexandra Zeitz (Global Economic Governance Programme, University of Oxford)
Popular accounts of the 2008-2009 financial crisis have squarely blamed the crisis on shoddy corporate governance; newspaper headlines targeted greedy bankers and sloppy executives. Academic analysts have sought to investigatethe relationship between management and financial stability in a more nuanced fashion, studying how corporate governance structures might affect risk-taking, short-sightedness, and other behaviours contributory to crisis. In Kevin James and Dimitrios Tsomocos’ February 26 PEFM presentation and the subsequent discussion, it became clear that economists have yet to settle on an empirical account of exactly how governance matters. While most in the room agreed that corporate governance matters for financial stability and growth, the challenge appears to be how to measure and encourage good corporate governance.
The presentation began with a puzzle: how do we know good corporate governance when we see it? James argued, and many agreed, that standard measures of good corporate governance in the financial sector do not accurately capture ‘good governance’. For instance, assessments of corporate governance have long been based on the degree of shareholder influence. But Colin Mayer and others have pointed out that this can be misguided, since shareholders, especially short-term ones, may in fact encourage excessive risk-taking rather than acting as a stabilizing force.
How then to measure good corporate governance? James presented an alternative indicator (which proved very contentious with the audience): the volatility in stock prices, or idiosyncratic standard deviation (ISD). The measure is premised on a model that reasons that managers are torn between maximizing their immediate reputation and the long-run value of the firm. When abnormally poor governance structures and high market opacity allow managers to prioritize their short-term reputation, they will do this, leading to greater riskiness and higher relative stock price volatility compared to the industry average.
James demonstrated how this measure of volatility in the United States was correlated with particular historical facts: volatility remained high in the late 19th century, a time of frequent financial crises and low growth (although he conceded that data limitations meant he was measuring overall volatility, not volatility variance relative to industry average, during this early period). From the 1930s, following the 1929 stock market crash, relative volatility (properly measured) steadily decreased and then remained low until the last quarter of the 20th century, when it began to increase, returning to pre-1929 levels again just prior to the 2008-2009 financial crisis. James, Tsomocos and the other authors of this paper see the creation of the Securities and Exchange Commission (SEC) and related laws in 1933 (prompted by the stock market crash and resulting depression) as the primary explanation for the decline in volatility, which they take as their indicator of improvement in corporate governance. The reversion of higher volatility in the decade preceding the latest global crisis was the result of market participants circumventing the SEC (using the analogy of an antibiotic losing its effectiveness over time as the bugs evolve).
These historical extrapolations underpinned the policy recommendations of the presenters: concentrate on improving transparency in markets. They argued that macroprudential policies aimed at (repeatedly) raising capital ratios and slowing credit booms do little to prevent crisis and may be harmful for growth. Therefore, they suggested that energy should not be invested in yet further (upward) iterations of Basel standards, but rather in establishing a new, ‘global SEC,’ to radically increase transparency in markets.
Their analytical methodology and the derived policy prescription was, however, subject to fairly incisive critique from the audience. Many in the audience questioned whether volatility could in fact be used as a reliable measure of corporate governance—changes in relative volatility over time could be explained by many factors other than the quality of governance. Furthermore, given that stock price volatility (however caused) is likely to be responsive to the level of transparency in a market, it is unsurprising that regulatory measures intended to increase transparency should reduce volatility—without this implying anything about governance.
Nevertheless, the decline in stock price volatility in the 1930s and its more recent recovery in the run up to the global crisis was an interesting finding, which arguably merits analysis even if it doesn’t measure governance (but rather some other underlying dynamic).
But it was the all-important policy conclusions that provoked the greatest debate. Why throw macroprudential policy out with the bathwater? Given the complexity of the financial sector and financial crises, it would seem too simplistic to reduce the causes of crisis to a single factor and a mistake to dismiss the usefulness of all other recent policy interventions and reform of instruments. It is also unclear whether increasing transparency would be sufficient to address the corporate governance flaws that continue to affect the industry. Will increased transparency, for example, serve alone to tackle the ethical and normative dimensions of governance (which arguably lay at the heart of the problem)?
The data presented at Thursday’s seminar made for a rich and dynamic discussion. Corporate governance matters for economic and financial stability—on that much all the participants agreed. But the debate on how best to measure corporate governance and how to improve it will continue.