Personal Blogs

I have recently started studying with the OU because I wanted to learn about economics. I find it a fascinating subject, but know almost nothing about it.

A cynic might say that makes me indistinguishable from most economists. I couldn't possibly comment, although I hope that by the time I've finished my studies, I will.

I am still at an early stage of my studies, currently doing DD101 "introduction to social sciences", which the OU recommend as the best place to start with studying economics.

So, this is going to be the first of an occasional series of blogs about the economics issues of the day, from the point of view of someone who doesn't understand very much about them. Hopefully they'll get better informed and more insightful over time.

The subject of today's blog is the role of shareholder involvement in the recent banking crisis. I heard a fascinating piece on Today this morning (listen to it here) talking about why the banking system went so horribly wrong. There were many reasons put forward, but one that particularly caught my attention was the role of shareholders.

The theory was that shareholders in banks were not exercising their duty to ensure that the banks were acting their best interests. In theory, shareholders in banks should always vote to ensure that banks act in their interests, because, well, it's in their interest. So for example, rational shareholders should never approve the payout of excessive bonuses (ie bonuses greater than strictly needed to attract and incentivise good staff), because keeping bonuses to more reasonable levels would leave more money to be paid to shareholders as dividends. Rational shareholders should also not allow the boards of banks to implement strategies involving crazy amounts of risk.

But clearly, they did. Why is that?

I don't really know, but there are 2 things that strike me as contributing to the problem. The first is the increasing popularity of high frequency trading, now estimated to account for 70% of all trades. High frequency traders have no interest in corporate governance. Their strategy is based on micro-fluctuations in share prices over minutes or even seconds, and the corporate strategies of the companies they are buying are therefore irrelevant to them.

The second is that a large number of shares are held by pension funds (and other equity based funds), and there is therefore an extra layer of separation between the shareholders and the companies they own. Much of my pension fund is invested in equities, but I have no involvement in the companies my fund has invested in, as I don't directly own the shares. That's the job of my pension's fund manager, and I have to trust that he or she is doing a good job of voting responsibly at shareholder meetings.

But can I trust in that?

I don't know. But I'm a bit worried that there may be a problem here. Pension fund managers are highly paid city types. People in banks who take excessive bonuses are highly paid city types. On the whole, people tend to look after their own. Whose interest is my fund manager most closely aligned with? It's probably easier to approve a payout of excessive bonuses when those bonuses are going to your mates.

And is my fund manager incentivised to look after the prospects for long-term stable growth of the companies my pension is invested in, or is there an incentive for taking risks with the potential for big gains in the short term, even if it does all go tits up a few years down the line?

I don't know the answers to any of these questions. This is part of the reason why I'm keen to study economics. But the questions do worry me.

Are you worried? Let me know in the comments below.