Takeovers: an agency problem?

The Treasury Select Committee says the FSA "should and could have intervened in RBS’s takeover of ABN AMRO."

Really? This runs into the objection raised by Hector Sants (par 23) - that the regulator shouldn't be "a 'shadow director' protecting firms from poor commercial decisions." An intelligent regulatory regime - which hindsight tells us didn't exist in 2007 - would allow firms to fail through their own stupidity.

Where there is a case for the regulator to intervene in takeovers is if some market failure is involved. The obvious such failure - that takeovers reduce competition - did not apply in the RBS/ABN Amro case. But might another failure have been involved that justifies the TSC's stance? A paper by Thomas Gall and Andrea Canidio suggests maybe, because there can be failure in the principal-agent relationship between shareholders and management.

Imagine, they say, that an agent can choose between two tasks: a routine one and a complex, high-profile one such as launching a new product. If the agent wants to signal that he has high ability, he might well prefer the latter. But this could well be inefficient from the firm's point of view - because such projects distract employees from important but mundane tasks, or because the payoffs to such projects are small or uncertain. In this case, they say:    

Idleness can be desirable for a principal if, because of career concerns, employees have an incentive to over-invest in complex, visible tasks that generate signals about the agent's ability...To balance their employees' bias toward visible tasks, firms may distort their organizational investments toward employee perks that are complementary to idleness. That is, employee perks that seem to encourage idleness are actually meant do so.

They cite the contrast between Google, which offers lots of strange perks to employees, and Apple, which doesn't.

Doesn't this line of thinking apply to CEOs too? Often they want to undertake mergers because of the buzz of the deal or for ego gratification (pdf). But such mergers are often (pdf) bad for shareholders, as was pointed out at the time of ABN's takeover.

Herein, you might argue, lies a case for regulation. Contracts between principals (shareholders) and agents (CEOs) fail to solve the problem identified by Gall and Canidio. They over-incentivize CEOs to do big deals, and under-incentivize them to stick to their knitting and focus on running companies well day-to-day. Regulation is then needed to rein in CEOs egomania and hubris.

However, that word "might" is doing a lot of work in that paragraph. Shareholders can in theory stop CEOs doing deals: there's nothing to stop them writing a contract forbidding them to aquire "assets" over a certain size." But they don't do this. This is not (just) because they lack power over CEOs, but because they too often get carried away by bid euphoria; shareholders, remember, approved RBS's takeover of ABN AMRO.

Perhaps, then, shareholders need protecting not (just) from self-interested CEOs, but from their own carelessness. Which raises the question: if shareholders need an organization as sloppy as government to protect them, what useful function are they serving?

Comments

[Anonymous]

Seems like we now have a corporate Nanny State!

[Frank H Little]

Point taken, but perhaps the government and the financial authorities should have informed RBS that they were not going to be rescued by the state if the bank's adventure failed. Then stuck to it.

[Metatone]

Surely, in the absence of a functioning failure regime, that could allow a merged RBS/ABN to fail without serious damage to the overall system (or managed the failure to that effect) then the regulators should have used the tools at their disposal...

Now you can say regulators should have created a functioning failure regime, but alas, they were not empowered by politicians to do so.

Point being, it's not just about an intelligent regulatory scheme, but also one empowered by politicians. The neo-liberal capture of discourse did for that at the time, alas.

Of course, it should be noted that there are many questions over the value of cross-border mergers between banks, which should also have rung alarm bells for regulators. This is not to say every cross-border merger is bad, but they should all trigger investigation of the complexities the cross-border status adds to the failure regime - regulators did a better job of asking questions of the structures of Santander UK, for example. Had they at least done as much with RBS/ABN, the story may have rolled in a different direction.

[Frances Coppola]

The FSA isn't there to protect shareholders from the consequences of their own failure to oppose risky and stupid management decisions. It's there to protect taxpayers and the public in general from the consequences of risky and stupid decisions by management and shareholders of systemically-important banks.

Therefore, in the absence of a regulatory regime that enabled a bank like RBS to fail safely, timely intervention to prevent catastrophic management decisions or, at least, limit their impact was absolutely within the FSA's remit. That it did not do so is a serious indictment of the FSA's own management. Sants has completely missed the point - and in so doing demonstrated his incompetence.

[Anonymous]

"Perhaps, then, shareholders need protecting not (just) from self-interested CEOs, but from their own carelessness. Which raises the question: if shareholders need an organization as sloppy as government to protect them, what useful function are they serving?"

Perhaps it is corporate governance that is failing. Separation of ownership from control will produce Principal-Agent problems as described above.

Better corporate governance is likely to flow from having a shareholder/employee jointly elected supervisory board which would then jointly appoint an executive board. Principal-Agent problems would be greatly reduced by this arrangement, I suggest.

With proper corporate governance mechanisms in place there should be no need for regulation, which in the UK is very weak anyway.

And of course, the other great regulatory mechanism is the market. The sooner proper markets for the banks and the energy sector are introduced the sooner can the virtually useless regulatory authorities be abolished and the cash savings released for better purposes.

Strong competition law and reformed corporate governance are what is needed, not expensive and captured regulators.

[From Arse To Elbow]

The "perks for idleness" employed by Google are actually intended to foster innovation, most famously the ability of staff to spend 20% of their time on self-directed projects. This is not a free-for-all (Google regularly culls projects) but a deliberate bottom-up approach to developing new products. Contrast this with banking's top-down approach to "financial innovation".

Google shareholders are no more active or virtuous than RBS's (witness their recent panic over a mangled press release). What is different is the corporate culture, which reflects the wider culture of their respective industries. As banking will never lose its need for probity, caution and mistrust, its probably unrealistic to expect it to produce anything other than a command-and-control management style. The best it can hope to do is weed out egotistical execs.

Pre-FSA, the Governor of the BoE would fulfill the role of marking someone's card. The modern regulatory regime has failed to provide an adequate substitute, let alone an improvement, as corporate business mores have infected banking since the 80s.

[Churm Rincewind]

Frances Coppola suggests that the FSA is "there to protect taxpayers and the public in general from the consequences of risky and stupid decisions by management and shareholders of systemically-important banks". Ah, the wisdom of hindsight.

[Frances Coppola]

Churm, that has always been the FSA's function, though maybe that was not made clear enough when it was established. That it failed to do this is an indictment of its management. They were asleep on the job.

[adr arbitrage]

Hi Annon, The obvious such failure - that takeovers reduce competition - did not apply in the RBS/ABN Amro case and thats correct