Banks occupy a central position in society and the economy. People have passionate opinions about them – some arguably misguided, some appropriately challenging. I hope to do three things here that might enhance public debate.
First, I want to offer a conceptual model and some vocabulary – tools I find useful for talking about enterprise generally. I make no great claims for my model. I’m not writing for an academic audience.
There are actually two models – or maybe they’re metaphors. My hope is that moving back and forth between them will yield some insight. Those insights apply to all kinds of companies, by the way. We need to re-think the concept of a corporation. Banks just need it more than other corporations do.
Second, I wish to suggest that the objective a typical bank board pursues is a balanced response to stakeholder claims – as opposed, that is, to maximizing the wealth of one class of stakeholders. That’s part of my model.
Finally, I will discuss the matter of worthy causes clamoring for board attention. My personal view is that they cannot be wholly dismissed.
What am I trying to accomplish? Brain-stretching. I note challenges facing traditional corporations, describe other organizational forms and highlight the value-allocation decisions boards must make, not because I favor moving business into some new construct, or expect parliaments to alter corporations acts, but to encourage directors to think about their job description – including the unwritten parts.
Some of what follows is intentionally provocative. The times call for unconventional thinking. There have been a couple of electoral surprises recently. “Left” and “right” no longer have stable meanings. Community expectations are changing. Executives in every sector of the economy perceive a rising tide of distrust. It may make sense to re-examine how business explains itself to a skeptical public, and see if we believe what we’re saying.
Model and Vocabulary
A bank is an enterprise. The task of every enterprise is to offer goods and services at prices that exceed the aggregate cost of their ingredients but are no higher than those of alternative providers. Doing that creates value. The proof is that you have customers.
Some ingredients are tangible and obvious: bricks to build a house, clay to make bricks, men and machines to dig up the clay. Some are intangible: energy to bake the bricks, the skills that operators of machines acquire, the transportation of the bricks to market.
I like to use the word, “enterprise,” for value creation – both the activity and entities that engage in it – because it is neutral as to distribution and structure. The purpose of an enterprise is value creation, full stop. An enterprise can take a multitude of organizational forms.
How the value an enterprise creates is shared among the parties at interest is a function of history and negotiation. “History” is shorthand for political arrangements and resource endowments – in other words, luck. Negotiations are conducted in accordance with a mixture of written and unwritten rules regarding process and entitlement that we might think of as a virtual constitution. Every constitution is subject to amendment.
“Stakeholders” is another name for parties at interest. The term covers anyone who receives some of the revenue and other benefits an enterprise generates, or suffers from collateral damage the enterprise inflicts – e.g., by polluting. Shareholders are stakeholders, of course, but so are customers, creditors, employees, executives, directors, suppliers, the government in various capacities and the community. By echoing the word, “shareholders,” the word, “stakeholders,” quietly asserts that all these people have a form of ownership rights.
Freedom to pollute, since I mentioned pollution, is a sort of negative ingredient. Adding it to the mix imposes a cost on the community. It may also increase the profit shareholders enjoy – for example because they are free not to treat their waste water before releasing it into the river. Every kind of freedom can be viewed as an ownership right. Some freedoms turn out to be value-enhancing and some do not.
Banks have a lot of stakeholders and they make a lot of noise. I don’t know whether that should be regarded as part of the business model, but it is definitely an important fact about banks. It is one of the things that makes banking hard.
How Business Explains Itself
The traditional apologia begins with Adam Smith’s “invisible hand” – the notion that honest pursuit of self-interest takes an economy to an equilibrium state that maximizes total welfare. This is actually only true for a given initial allocation of resources. Grossly unequal distributions of wealth mean less total welfare, and the remedy is more likely to be sought in politics than in classical economics – as we have lately seen. But never mind. Competition is the hero of the story and businesspeople love retelling it.
Believing in economics and acquainted with corporate law, directors of public companies will often tell you – or some will – that their job is maximizing shareholder wealth, with broader outcomes being the market’s affair. They may even assert that the purpose of the company on whose board they serve is “to make a profit.“
This wins business little support. Self-interest may be constructive from a macro-economic perspective, as Adam Smith tells us, but it’s unattractive at a personal level. A robust defense of profit-seeking reminds people of how handsomely corporate leaders are paid. More fundamentally, this is the wrong way to think about profit. And it doesn’t describe what companies actually do.
‘ll start with profit. One of the ingredients an enterprise requires in order to deliver goods and services is the use over time of a certain amount of financial capital. Suppliers of capital must be adequately compensated – as must employees and executives as suppliers of their time and talent – or they will not participate in the project. Profit has to cover the cost of employing that capital, which may be thought of as invisible rent.
If profit consistently exceeds that rent, the value of owning the enterprise – i.e., the share price – will go up. If what businesspeople mean when they say that their purpose is to maximize shareholder wealth is that their role is to marshal ingredients so as to achieve that result, I have no argument. But that way of putting it can alienate their fellow citizens, and it gives the wrong message to directors, executives and impressionable adolescents. As the management guru Peter Drucker put it years ago, profit is a means, not an end. The end to focus on, and talk about, is value creation.
Regarding what companies and the boards that guide them actually do – as opposed, that is, to single-mindedly chasing profits – let me draw a picture of reality as I see it. Many communities pass laws to limit pollution. A logical corollary to the assertion that a board’s only responsibility is maximizing shareholder value would be an obligation to oppose or legally circumvent those laws. The odd academic or journalistic provocateur may argue that such an obligation exists, but practical business executives do not. Just for starters, they know that public opposition could entail brand damage, and that even quiet foot-dragging would mean signficant legal expenses and the possibility of fines. Depending on what damage the effluent does or is alleged to do, how much treating it is projected to cost, a host of technical detail regarding those issues, how important a clean river seems to be to the general population, a judgment about how aggressive environmental activists and relevant government agencies will be, and their personal values, directors may support, attempt to clarify, improve or frustrate such legislation.
Anyone who has been a company director or served on the governing council of a school or charity knows what the discussion will be like. Boards work hard to get a handle on the facts, pay attention to community expectations, and try to compare costs and benefits some of which are impossible to quantify. In the end, part of what they do is make moral choices. They call them “business decisions.” You can be a cynic if you want, but directors want to do the right thing. Figuring out what the right thing is can be quite difficult.
A Harvard Business School professor and a management consultant have published a couple of articles promoting a strategy they call “shared value,” which makes doing the right thing somewhat easier. Their idea is that corporations should pursue initiatives that benefit the communities they operate in – without worrying too much about immediate returns to their shareholders. Examples include facilitating the emergence of a cluster of associated local businesses, or reducing the amount of energy-consuming transportation and packaging in their supply chain. Conceiving these as businessinitiatives rather than charity is the first step in making the flow of benefits sustainable.
Porter and Kramer see this as a new form of capitalism. If it is, I think I like it. A number of major companies have embraced the concept. A group of academics have attacked it. There is a “Shared Value Project” in several countries, including Australia. The question of purpose is occupying some very good minds.
To be clear, my point is not that directors ought to consider the interests of all stakeholders, but that they already do. I personally believe that companies have obligations to stakeholders other than shareholders. I believe banks have obligations that go beyond those of ordinary companies. Reasonable people can debate those propositions. Boards behave as if they are true. That’s the way the system works.
The Right Home
Some people, observing that banks grant options to the rest of the economy, conclude that absorbing risk is banking’s purpose. That’s a dangerous view. Banks accept risk in order to provide the services they do, but they should not seek risk the way general insurance companies do. They should strive to minimize the risks they have to take. I regard that as fundamental banker wisdom.
I know that some people believe a bank can take any risk it wants, so long as the price is appropriate. Within the normal range of loan transactions, yes, a little more risk and a little more interest go hand in hand. But adequate compensation for a lot more risk requires a big discount from par. Making – or more likely, buying – a very risky loan is a form of equity investing. Different skills are required. A very different balance sheet is required. Until such time as the borrower repays, you can have big arguments about valuation with your accountants and regulators, which is difficult for banks. You are talking about a different business model. You want to be a hedge fund
Enterprise needs the right home. There must be a congenial organization or organizational construct for value creation to happen in. Its constitution should be consistent with the character of the enterprise. The right home is often a corporation, but that isn’t the only possibility. For much of the 19th Century, most English banks were small partnerships, which made bankers cautious by increasing their personal risk. This worked when their business was seasonal lending against inventory and receivables – and entirely domestic. It didn’t work as well for international business, which is why overseas banks and trading enterprises were among the first to be given the privilege of incorporation.
Other venues in which value can be created include (without limitation) a joint venture, a charitable foundation, a government agency, a university, a political party and a meeting. Not all of these are businesses, or even organizations. That’s why I use the awkward phrase, “organizational construct.”
A corporation has distinct advantages as a home for enterprise, starting with the fact that we know how it works. It has a constitution that is written. Well, mostly written. It has transferable and therefore permanent capital, limited liability for the owners, and a relatively clear decision-making process.
Large public corporations also have limitations. Quoted shares make focus on currentshareholder wealth inevitable – which can give companies a short-term bias that puts many value creation opportunities out of reach. Transferable shares make it easy for institutional owners to sell if they sense problems, rather than sticking around and exercising stewardship.
Other organizational forms have their own strengths and weaknesses. Members of a private partnership worry more about personal risk and reputation than shareholders of public companies do. Illiquid partnership interests promote long-term thinking, which in principle ought to be value-enhancing. On the other hand, the mutual trust and oversight a partnership requires are difficult to sustain above a certain size, and the entity lacks financial flexibility. Its dividend policy is the partners’ retirement schedule. Its constitution is a form of musical chairs. The partners leading a successful firm will always be in a position to enrich themselves by going public – in doing so disappointing the expectations of younger partners and aspiring associates. This can make such a firm unstable. Individuals managing successful private partnerships address this issue by describing themselves as “custodians of the franchise.”
Institutions that pool and deploy a community’s resources are sometimes seen to do better without shareholders. Many savings institutions and life insurance companies used to be mutual entities. With no shareholders to challenge the chief executive, however, some took egregious risks. Others became hopelessly bureaucratic. A man who knew the institution well once told me that the then-mutual Metropolitan Life Insurance Company was “owned” by its own law department. Most mutual organizations in the U.S. and U.K. have been converted to normal corporations.
Learning from China
The corporations acts of Anglo-Saxon countries are pretty strict about ownership rights. The world is not. That being the case, looking at things exclusively through a Western legal lens distorts reality. I learned that lesson twenty years ago in China, where I helped establish the country’s first investment banking firm, China International Capital Corporation (“CICC”).
I assumed before I arrived in Beijing that much of CICC’s work would be restructuring state-owned enterprises (“SOEs”). So when I had dinner with a vice minister of planning, I asked him what the hardest part of restructuring was. He answered immediately: “Finding the owner.” He went on to explain that ownership meant influence on operations and access to some of the value an SOE generated. That didn’t have to involve common shares. In the abstract, and as a good Communist, he regarded “the people” as the owners. But he had to identify the ones to talk to.
Common shares do have their uses. CICC’s main work turned out to be taking SOEs public, which created owners in the conventional sense, and gave everyone an interest in facilitating the changes that made an initial public offering (“IPO”) possible. SOEs had to be “corporatized.” Privileges enjoyed by individuals and communities associated with the SOE had to be covered by contracts. New shares had to be sold, so the restructured SOE had to be profitable. It was assumed the price would “pop” upward the day of the launch, so the new shares had to be allocated. All this involved political decisions, which foreign bankers could not advise on. But watching the process gave me a new understanding of an enterprise as an arena in which stakeholders contend, and an appreciation of the difficulty and importance of a balanced response to their claims on value.
I expect a range of reactions to the account of ownership in the last few paragraphs. A generation after the birth of “capitalism with Chinese characteristics,” a few readers may still be outraged by communism. Others will laugh and point to my story as evidence that “even the Communists” see the merits of unambiguous ownership. Most will insist that directors of corporations have a clear and simple duty and cannot start rewriting the law.
All these views are understandable. Not all of them are valid. Full-on socialism has been a failure most places it was tried, and I’m not endorsing it. Private property is the hook in the ceiling that the tinkling chandelier of enterprise hangs from – with self-interest in the role of gravity – but mutuality exists in many forms. And directors do not have simple jobs.
The law treats corporations (including banks) as sentient beings empowered to pursue their own self-interest provided they obey whatever rules society has made for them. Their self-interest is identical with shareholders’ interest. What interests shareholders is primarily dividends and price appreciation. The arena in which corporations seek profit is “the marketplace.” Good outcomes are the product of competition among corporations, as per Adam Smith. It is not that complicated.
Except that it is. You can also regard a corporation, and especially a bank, as a parliament of stakeholders, an internal marketplace, a clearinghouse for stakeholder interests. Employees want higher salaries; shareholders want to control costs. Politicians want the easy credit they believe will revive the economy and get them re-elected; prudential supervisors are risk-averse. Environmental activists want banks to stop financing coal companies; management wants to respect long-standing relationships. A bank chief executive tries to deliver for shareholders but encounters a stream of distractions. Eventually he comes to understand that coping with “distractions” is part of his job. He is answerable to everyone. The outcome he must deliver is balance.
Markets and intelligent market participants are good at finding the point of balance in a complex situation – an activity economists call “price discovery,” politicians call “consensus-building” and investment bankers call “deal-making.” Boards perform a similar function. They represent shareholders, to be sure, and favor them when they can, but inside the boardroom, directors are arbitrators as much as advocates. Smart boards try to understand the moral force of stakeholder claims and anticipate shifts in community expectations.
Implicit in the uncomplicated, sentient-being view of corporate entities is an assumption that the prices of most ingredients are set by “the market.” The challenge is to combine them efficiently and market the resulting products skillfully. Competition is external. Banks are cross-subsidy machines, however, so there is also internal contention among stakeholders who want outcomes for which there is no market. A director of a bank can see herself as a zoo-keeper who cares for the sentient being or as speaker of the parliament. I think she is both.
“License to operate” is a currently popular name for the mixture of legal authorization and public trust banks must maintain to be in business. (All major public companies need some form of such a license.) A bank’s license comes with fiduciary obligations to shareholders as a group, but also to unsophisticated retail customers who buy products they will never fully understand, and to the community at large, which wants financial stability. “Maximizing shareholder wealth” is at best a partial job description.
The license already requires a bank chief executive, as prime minister of his enterprise, to submit to question time on a regular basis. The evolutionary path banks are on will make the parliament-of-stakeholders metaphor increasingly appropriate.
Historically, banks have presented themselves, and thought about themselves, as safely situated behind thick walls. More recently, their boundaries have grown porous. Examples of this phenomenon include the migration of data to the cloud just as the value of data is being recognized; the propensity of young people to view every job as a gig, giving banks a work force of strangers; and the growth of cyber-terrorism, which makes shared interest in protecting financial infrastructure outweigh competitive instincts. If you carry these trends to their logical conclusions, the distinction between “internal” and “external” becomes quite fuzzy. Mutuality grows. Everyone is everyone else’ stakeholder. Ambitious businesspeople may object to this “vegetarian capitalism,” as it might be called, but for the vulnerable, political creatures that banks have always been, “serving stakeholders” is the right motto.
Hold those thoughts while I describe an enterprise that wasn’t an organization, and introduce (if you haven’t heard of it) the concept of a mixed game. As it happens, this story comes from the world of bank regulation, but there’s no message in that.
A Game of Breakfast
When an American bank exhausts its capital, it is supposed to be closed by its prudential supervisor – the Office of the Comptroller of the Currency (“OCC”) if it‘s a national bank, otherwise by the state banking commission that chartered it. When a bank is closed, the Federal Deposit Insurance Corporation (“FDIC”) automatically becomes the receiver. From 1991 to 1994, I ran the division of resolutions at the FDIC. Our job was to persuade another bank to assume the deposits of a failing bank and to purchase as many of its assets as possible. It took six weeks to arrange even the simplest resolution, and four or five months in complex cases. The chartering authority had to time its terminal examination of a suspect bank to accommodate the FDIC. If the bank in question was state-chartered, the Fed often got involved, and if, as sometimes happened, a bank experienced liquidity pressure as it waited to be put out of its misery, the Fed alone could provide support.
Anyone who has ever worked in a bureaucracy knows that overlapping powers and interconnected responsibilities of this sort can result in friction and turf wars. That simply wasn’t acceptable in 1991 and 1992. Four or five banks were failing every week. A bungled transaction had the potential to start a cascade of bank runs. Preventing panic created value for the whole country – not to mention preserving regulatory reputations.
The solution, invented by my predecessor, was a weekly breakfast, attended by two or three senior civil servants from each agency. Most banks are closed on Friday afternoons, so the breakfast was on Friday morning to permit last-minute updates. There was no agenda. There were no minutes. The OCC was always the host – I never found out why – but they never claimed it was “their” meeting. The “constitution” was entirely unwritten and there were only two rules: no surprises and no feuds. You were expected to tell your colleagues what you were planning, and mention any lurking policy issues. And if you were angry about something that had happened during the week, you had to put it on the table Friday.
You might not call that weekly breakfast an enterprise. Officially, it didn’t even exist. Not existing was crucial to its success. But it provided a home for the value creation of smooth resolutions, an enterprise in which each of the attendees had a stake. It helped to make the resolution process a “cooperation game,” in which none of the three federal agencies sought to look better than their cousins.
The opposite of a cooperation game is the “zero-sum game,” in which every gain is a loss to another player. In between are “mixed games,” the object of which is to agree on a division of value without destroying too much of it negotiating. Lengthy negotiations erode value because they distract management from productive activities. More fundamentally, getting the other players in a mixed game to agree to a particular division of whatever prize you are fighting over requires you to convince them of your sincerity in making a “final” offer or “drawing a line in the sand.” To do that, you must demonstrate a willingness to sustain losses if the offer is rejected or the line is crossed. An example would be a company that abruptly cuts prices and increases its advertising spend to prove to an interloper that it will defend its market share “at all costs.”
Competition with the other companies in a market can be a zero-sum game and be good for the economy. Competition law puts limits on cooperation. On the other hand, stakeholders of the same enterprise “ought” to be playing a cooperation game. Life teaches us not to expect that. Mostly we play mixed games.
In between a large public corporation and a weekly get-together, there is a wide range of organizational forms and constructs. The concept of a mixed game helps us understand many of them.
Out-sourcing is a good example. Banks have done a lot of it – and some are beginning to wish they hadn’t. The vendor has an interest in minimizing the cost of fulfilling his contractual obligations. The purchaser of services will have put service standards into the contract, and will hold the vendor to them. But if, as the years pass, the vendor finds he cannot make a profit without cutting corners, he is likely to conclude that cutting corners is “fair.” Maintenance will get deferred. Staff quality will decline. Even with contractual inspection rights and remediation mechanisms, the purchaser is likely to suffer. The agreement between the parties will have to be restructured. Signing an out-sourcing contract amounts to creating a joint venture. A joint venture is an agreement to play a mixed game for an indefinite period.
Worthy Causes and Complex Risk Decisions
Among the stakeholders boards must respond to today are advocates of various causes. They may be shareholders who care more about some aspect of corporate conduct – the company’s carbon footprint, for example – than they do about the dividend. They may be community leaders who want to see their tribe or gender better represented in senior management.
Many executives and non-executive directors believe strongly that burdening corporations with social objectives is inappropriate, no matter how worthy those objectives might be. It will make the enterprise inefficient, they argue. Doing more than the law requires may sound virtuous but it is not what the other shareholders signed up for. And to be honest, moderating climate change is not our core competence.
Others contend that large public corporations are among society’s most important institutions. Their license to operate creates an obligation to help solve society’s problems. There is no reason they shouldn’t be conscripted, just as individuals are in time of war. Global warming is an existential crisis, after all.
There are two arguments going on here. One has to do with capability, the other with duty. The answer to the first is easy.
To those who see the statement, “We serve shareholders,” as an adequate description of what boards do and are capable of, my first response is to ask, “Which shareholders?” The choice of a corporate strategy is also a decision about risk appetite, and appetites vary. Some shareholders want reliable dividends. Some want growth and price appreciation, even at the cost of increased volatility. Shareholders may also be sorted into groups by reference to their time horizons and tax positions. Some want a quick profit. Those who would face significant capital gains taxes if they sold want to collect dividends forever. If boards can make choices about which shareholders to satisfy and which to disappoint, banks clearly have the capacity to allocate value among stakeholder groups. They do it all the time, in fact.
When a central bank lowers its benchmark interest rate, banks have to decide how much benefit to confer on borrowers by dropping loan rates, how much to claw back from depositors by lowering deposit rates – and whether in the process to widen the spread, which would benefit shareholders. These are questions of strategy but also of politics.
Or consider the process of recruiting a new chief executive. There’s a negotiation about her pay. And there’s a market for talent that can be cited to justify the outcome. Headhunters will give you compensation figures disclosed by other companies. But there is an allocation decision buried in this process. The board has to decide what managerial skills and record of past success the next chief executive has to have, what part of the market for talent that means the company is in, what share of the value the company creates in the next few years will go to the chief executive as compensation rather than to the shareholders as profit.
Whenever current value is allocated away from shareholders, whether to customers or executives or environmental protection, the decision is likely to be described as being “in the shareholders’ long-run best interest” or as representing “enlightened self-interest.” At best these are statements of intent. The future is profoundly uncertain. Long-run best interest is harder to calculate than we pretend. Judgment is required.
Well-constructed boards are good at making decisions that call for judgment. One might almost say that’s what they’re for. These “complex risk decisions,” to give them a name, involve apples-and-oranges situations where financial or legal analyses are not sufficient. Science, ethics, reputation, brand, staff morale, political reaction and changing industry structure may also be considerations.
Defining a company’s strategy is a complex risk decision. Choosing or firing a chief executive is a complex risk decision. The questions advocates of causes raise are similar. They need to be considered from multiple perspectives. On a distribution-neutral basis, what value can be created – for the bank and its community? What organizational arrangements are likely to maximize that value? How can the allocation of burden and reward be squared with relevant stakeholders? What is fair?
The best boards listen to experts if such exist, but know they can’t out-source responsibility for important choices. They bring to these decisions diversity of experience outside the boardroom, the mutual respect that comes from wrestling with difficult questions inside the boardroom, a bit of distance from the problem and with luck, collective wisdom. That’s my answer regarding capability.
But should boards engage in these debates? My personal view is a cautious “yes.” To reinforce an earlier observation, large public corporations are the most important institutions in modern society. Their license to operate makes them a public resource. If there is significant interest in an issue, boards might choose to investigate it, commissioning management and outside experts to help as necessary. If directors have conviction, they might speak out, and encourage their peers to join the conversation.
I accept that there could be costs to speaking out. A board should probably ration the occasions on which it does so. But this is a role large public companies are under increasing pressure to play. There will probably be costs to shirking.
Every enterprise is a joint venture among its stakeholders. They come together to create value but fight over its distribution. They are simultaneously allies and opponents. The work of a board involves satisfying, and by definition therefore disappointing, all stakeholders to some degree. It’s political work. We might call it “honoring” claims.
Honoring begins with listening. A company – or an industry, or business in general – must convince every class of stakeholder that it understands their frustrations, that it knows what they want and knows why they’re angry. This may sound ambitious, but it is more achievable than convincing people of your virtue.
If it can find the right voice, business might speak publicly about the ethical dilemmas it wrestles with. Many businesspeople will recoil from this suggestion, fearing they will lose control of the conversation. But who says we have control?
I’ll end with something quirky and hopefully therefore memorable. I read an article nearly forty years ago – I’ve saved it ever since – that describes a (presumably imaginary) game called “Chinese baseball.” It differs from the American version in only one respect. Whenever the ball is in play, any player may move the bases. This makes Chinese baseball more like life than most games are.
The author calls the game an “art.” He recommends that players, “Act from an instantaneous apprehension of the totality” – advice making the point that we all have more capacity to imagine and shape the future than we sometimes admit.
“We serve shareholders” is akin to “I was just following orders” – a dumbing down of the job, and an abdication of responsibility. Banks are servants of the whole community. There is no escaping the attendant complexity. But you can find the point of balance if you want to. And it is possible to cultivate good judgment. Honoring the legitimate claims of all stakeholders is common sense. It is what boards do. It is what they ought to do.
 Michael E. Porter and Michael R. Kramer, “Strategy and Society: The Link Between Competitive Advantage and Corporate Social Responsibility,” Harvard Business Review, December 2006 and “Creating Shared Value,” Harvard Business Review,January-February 2011.
 Andrew Crane, Guido Palazzo, Laura J. Spence and Dirk Matten, “Contesting the Value of ‘Creating Shared Value,’” California Management Review, Winter 2014.
 I was introduced to the concept of a mixed game by Thomas C. Schelling’s The Strategy of Conflict.
 Ralph G. H. Siu, “Management and the art of Chinese baseball,” The McKinsey Quarterly, Autumn 1978.