Simon Johnson's Blog, page 26

Goldman Sachs Concedes Existence Of Too Big To Fail

By Simon Johnson

Global megabanks and their friends are pushing back hard against the idea that additional reforms are needed – beyond what is supposed to be implemented as part of the Dodd-Frank 2010 financial legislation.  The latest salvo comes from Goldman Sachs which, in a recent report, “Measuring the TBTF effect on bond pricing,” denied there is any such thing as downside protection provided by the official sector to creditors of “too big to fail” financial conglomerates.

The Goldman document appears hot on the heels of similar arguments in papers by such organizations as Davis Polk (a leading law firm for big banks), the Bipartisan Policy Center (where the writing is done by a committee comprised mostly of people who work closely with big banks), and JP Morgan Chase (a big bank).  This is not any kind of conspiracy but rather parallel messages expressed by people with convergent interests, perhaps with the thought that a steady drumbeat will help sway the consensus back towards the banks’ point of view.  But the Goldman Sachs team actually concedes, point blank, that too big to fail does exist — punching a big hole in the case painstakingly built by its allies. 

Of course, the report puts a different spin on matters.  But if you add in a little bit of recent Goldman history – not mentioned in the report – the dangers of relying on their read of the data become readily apparent.

The Goldman analysts make clear that, even under the most favorable interpretation (i.e., theirs), very large financial institutions were able to borrow more cheaply than other financial firms at the height of the crisis in 2008-09.  The funding advantage they measure in the crisis looks (from their charts) to be in the range of 400-800 basis points.

In fact, there was further advantage to being one the very largest firms – remember that when hedge funds “ran” from Morgan Stanley, their destination was JP Morgan Chase (this point is not in the Goldman report, which conflates these two firms with other very large financial institutions).

The Goldman team shows there was an even larger advantage for huge non-bank financial companies than there was for banks, but they neglect to mention that their company was one of our large non-banks as the crisis intensified. Goldman was allowed to convert to become a bank holding company in September 2008, so that it could access the Fed’s discount window (i.e., increase its ability to borrow from the central bank.)  This conversion was allowed – or perhaps even urged by officials – precisely because they feared the consequences of Goldman failing.

Goldman executives argued long and hard in September 2008 that they were too big – and complex and generally important – to be allowed to fail.  Hank Paulson, then Secretary of the Treasury and former head of Goldman, felt strongly that the continued existence of his firm was essential to the well-functioning of the world economy.

The measured difference in spreads is obviously huge but even greater is the real funding advantage between not being able to borrow from the Fed (think CIT group, $80 billion total assets, which foundered and begged for assistance in fall 2009) and being able to borrow from the Fed (Goldman Sachs, $1.1 trillion total assets when it hit the rocks in mid-September 2008).

CIT, of course, was not a bank – hence the argument that it should not be allowed to borrow from the Fed.  But Goldman was not a bank either at the relevant point in time.

The issue of TBTF is not about the rules or the cost of credit relative to small banks in a period of calm.  It is about the availability of government support, broadly defined, when bad things happens – enabling the megabanks to borrow more cheaply than would otherwise be the case.

Goldman Sachs has downside protection available to it which a small or even medium-sized regional bank cannot hope to access.  This helps increase liquidity in their bonds and generally makes it easier to borrow in good times as well as bad.

The Goldman team argues that big banks show lower losses than smaller banks both in the recent credit cycle and during the S&L crisis.  But this uses F.D.I.C data and it necessarily masks all the other support provided by Fed support and various kinds of debt guarantees.  And Goldman does not cover the emerging market debt crisis of the early 1980s, which was all about big bank losses (with Citi at the center, as it was in 2007-08).

Goldman also argues that the funding advantage for megabanks today is smaller than it was in the crisis, indicating that there is no longer a TBTF issue in the minds of creditors.

But this rather indicates two points.  First, we are not in a crisis – so the immediate cash value of government support is lower, at least for short-term debt.  But the availability of that support in the future or in various unspecified difficult scenarios is hugely valuable, and a compelling reason to buy megabank debt.  Second, megabanks pay a complexity or opaqueness premium on their debt.  Creditors charge more than they would otherwise because they cannot see inside the largest of these groups to understand the risks they are taking and the shocks to which they are vulnerable.

The probability that the government (including the Fed) will protect all creditors fully has never been one and will never be zero.  Even at the height of the financial crisis, the credit default swap spread for some large financial institutions was high (e.g., for Morgan Stanley, so insuring its debt against default was expensive).

Creditors weigh the odds.  The spread on megabank debt over benchmarks is the combination of downside guarantees (which tend to lower spreads) and the complexity premium (which tends to increase spreads).

The real issue for too big to fail is: by how much does the prospect of government support lower spreads compared to what they would otherwise be.  The Goldman report acknowledges that too big to fail exists and distorts the market, but conveniently ignores the question of how big this distortion is really – and how it threatens to again bring down the economy.

The Politics of Intellectual Fashion

By James Kwak

Update: See bottom of post.

For years now, Anat Admati has been leading the charge for higher capital requirements for banks, especially large banks that benefit from government subsidies, first in a widely cited paper and more recently in her book with Martin Hellwig, The Banker’s New Clothes. Admati’s great service has been clearing the underbrush of misunderstandings and half-truths so that it is possible to have a debate about the benefits of higher capital requirements. Yet even after all this work, the media (and, of course, the banking lobby) continue to repeat claims that are simply false or highly misleading.

In another effort to beat back the tides of ignorance, Admati and Hellwig have put out a new document, “The Parade of the Bankers’ New Clothes Continues,” which catalogs and addresses these claims. In the simply false category, the most common is probably that capital is “set aside”; in fact, banking capital is assets minus liabilities, and the capital requirement places no restrictions on what a bank can do with those assets.

In the highly misleading category is the claim that higher capital requirements would force banks to reduce their lending. Banks can respond to higher capital requirements by raising more equity capital or by reducing their balance sheets. As Admati and Hellwig write, “If increased equity requirements cause banks to reduce their lending, the reason is that they do not want to increase their equity.” (If they can’t sell new shares, then they have more fundamental problems and probably shouldn’t be in business.) And why don’t they want to increase their equity? Because executives have one-way compensation packages based on return on equity, which is not adjusted for risk, so they don’t want to increase the denominator.

As Admati and Hellwig no doubt realize, this is not a battle that is going to be won solely with truth, light, and logic. The banking lobby has a vested interest in sowing confusion, with masterpieces like the IIF’s “report” claiming that higher capital requirements would shrink the global economy by 3.2 percent. And as long as bankers say that such-and-such a regulation will hurt growth and kill jobs, they will get a hearing. Ultimately, it’s all about politics, which was roughly the message of 13 Bankers. (Which is another reason why, in the long run, the only things that matter are campaign finance reform and early childhood education.)

Update: Banks’ unwillingness to increase equity by selling shares (or by not doing buybacks and dividends) is not simply due to one-sided bonus packages tied to ROE. A perhaps more serious problem is that of debt overhang. In short, if a company already has a lot of debt and its solvency is in question, shareholders will be reluctant to put more equity into the firm. That new money would mainly provide greater security to creditors, increasing the value of the firm’s debt, without providing much benefit to equity holders. So in this case, it’s not just the bank’s managers who resist selling new shares; they are actually doing so in the interests of shareholders (but not society). (For much more, see this paper by Admati et al.).

There are two solutions to this problem. First, if the bank really is insolvent, it should be shut down. Second, if it isn’t, regulators could force the bank to retain its earnings rather than paying them out in dividends and buybacks; over time, that would increase the amount of equity in the firm. Creditors could also refuse to lend to a bank that is too highly leveraged—but in the case of systemically important banks, creditors don’t really care, because they know they will be bailed out in a crisis. (That is undeniable, even for people who think that managers and shareholders might not be bailed out.) 

Liberty for Whom?

By James Kwak

I feel like I should have something deep and original to say about Corey Robin’s fascinating article on nineteenth-century European culture, Nietzsche, and the economic philosophy of Friedrich Hayek. In addition to the things I’m better known for, I studied European intellectual history at Berkeley, with Martin Jay no less, and I’m pretty sure Nietzsche figured somewhat prominently in my orals. But Robin has far surpassed my understanding of Nietzsche, which is almost twenty years old, anyway.

The story, in very simplified form, goes like this. For Nietzsche, and for other cultural elitists of late-nineteenth-century Europe, both the rise of the bourgeoisie and the specter of the working class were bad things—the former for its mindless materialism, the latter  for its egalitarian ideals, which threatened to drown the exceptional man among the masses. One set of Nietzsche’s descendants was the political theorists like Carl Schmitt, who “imagined political artists of great novelty and originality forcing their way through or past the filtering constraints of everyday life.” Another, which Robin focuses on in this article, is the “Austrian” school of economics led by Friedrich Hayek.

People often like to think of the Austrians as advocates of liberty, both for its Economics 101 properties (free choice in free markets, under certain assumptions, maximizes societal welfare) and its moral properties. Robin ties Hayek’s conception of liberty, however, back to Nietzche’s. Hayek cared about liberty for ultimately elitist reasons: liberty is not an end in itself, but a condition that enables the select few to make the world a better place. In his words, “The freedom that will be used by only one man in a million may be more important to society and more beneficial to the majority than any freedom that we all use.” And those select few are likely to be the rich, for only they have the requisite time and freedom from material concerns: “However important the independent owner of property may be for the economic order of a free society, his importance is perhaps even greater in the fields of thought and opinion, of tastes and beliefs.”

This idea is obviously echoed in Ayn Rand’s novels, which celebrate the individual genius standing out against the backdrop of collectivist mediocrity. It has also trickled into the contemporary conservative worship of the ultra-rich. The phrase today is “job creators” (whatever that means), but it has the same moralistic overtones as in Nietzsche and Hayek—a class of people who are better than the rest of us, on whom we depend for our salvation and prosperity, and whom we should not presume to question or constrain through, say, safety regulation or higher taxes (“penalizing success,” in the jargon).

I used to say that most Americans voted against their class interests because they thought they would one day be in the upper class: there’s some poll statistic floating around according to which X percent of Americans think they will one day be in the top 1 percent by income, where X is some high number like 40 or 45.  But today, five years after the financial crisis, with median income below where it was fifteen years ago and social mobility at developing-world levels, I can’t imagine many people really believe that vast riches are in their future. An alternative explanation is that many Americans just think the rich are better than they are and that it’s wrong to question your betters. (This is not inconsistent with George Lakoff’s model of the Strict Father and a hierarchical universe as the governing principle of modern conservative ideology.) Nietzsche would no doubt be horrified by most aspects of contemporary American society, but that might give him some comfort.

If the Fed Knows Banks Are Too Big, Why Doesn’t It Make Them Smaller?

By James Kwak

The Federal Reserve is serious—about something.

On May 2, The Wall Street Journal reported that regulators were pushing to require “very large banks to hold higher levels of capital,” including minimum levels of unsecured long-term debt, as part of an effort “to force banks to shrink voluntarily by making it expensive and onerous to be big and complex.” The article quoted Fed Governor Jeremy Stein, who said, “If after some time it has not delivered much of a change in the size and complexity of the largest of banks, one might conclude that the implicit tax was too small, and should be ratcheted up” (emphasis added). 

A few days later, Fed Governor Daniel Tarullo said roughly the same thing (emphasis added):

“‘The important question is not whether capital requirements for large banking firms need to be stronger than those included in Basel III and the agreement on capital surcharges, but how to make them so,’ said Mr. Tarullo, adding later that even with those measures in place it ‘would leave more too-big-to-fail risk than I think is prudent.‘”

Tarullo recommended higher capital requirements and long-term debt requirements for systemically risky financial institutions.

Last week, Governor of Governors Ben Bernanke quoted from the same talking points (emphasis added):

“Mr. Bernanke said the Fed could push banks to maintain a higher leverage ratio, hold certain types of debt favored by regulators, or other steps to give the largest firms a ‘strong incentive to reduce their size, complexity, interconnectedness.’

“The Fed chairman acknowledged growing concerns that some financial companies remain so big and complex the government would have to step in to prevent their collapse and said more needs to be done to eliminate that risk.”

It’s important to note exactly what Stein, Tarullo, and Bernanke are all saying.

Here’s what they’re not saying: Too-big-to-fail banks enjoy implicit subsidies and impose externalities on the rest of us; therefore those subsidies and externalities should be priced; and then those banks can decide whether they want to absorb those costs or make themselves smaller. 
Here’s what they are saying: Too-big-to-fail banks are too big and complex and pose a systemic risk to all of us; therefore they need to become smaller and less complex; and the Fed will tweak the regulations until they become smaller and less complex.

What’s remarkable about this? These three men—probably the three most important on the Board of Governors when it comes to systemic risk regulation (as opposed to monetary policy, for example)—all say that they know that the megabanks are too big and complex. They all say that accurate pricing of subsidies and externalities is not an end in itself.* They all say that the goal is smaller, less complex banks.

But here’s what baffles me: If the goal is smaller, less complex banks, why not just mandate smaller, less complex banks? Why beat around the bush with capital requirements and minimum long-term debt levels? Those tools might be appropriate if you think huge, complex banks should exist but you want to make them safer. But if you’ve already concluded that banks need to be smaller and less complex, then they’re just a waste of time.

They also betray a frightening naivete regarding corporate governance. The theory is that higher capital requirements, for example, will lower banks’ profits, which will upset shareholders, who will eventually force the board of directors to eventually convince the CEO to break up his empire. This scenario, unfortunately, depends on the premise that American corporations are run for the benefit of their shareholders, which is only roughly true, and even that often requires long, expensive, and messy shareholder activist campaigns.

Instead, there’s an obvious solution: rules that limit the size and scope of financial institutions. But Bernanke has ruled out “arbitrary” size caps in favor of his cute regulatory dial-tweaking.

Again, Bernanke’s position might be defensible if he wasn’t already sure that today’s banks are too big and complex. Then it might make sense to tweak the incentives and see how the market reacts. But if he knows they are too big and complex, he should eliminate that risk in the simplest, most direct way possible. If he’s not sure how much smaller and simpler banks need to be, he can do it in steps: set one set of size and scope limits, see what he thinks about the outcome, and then set another set of limits if he’s still unhappy.

To use a crude analogy, let’s say we’re concerned about guns on airplanes. Ben Bernanke thinks, like I do, that guns on planes present an unacceptable risk to the safety of air travel. But his approach is to charge a $100 fee for anyone who wants to bring a gun onto a plane. If people keep bringing guns on board, he’ll raise the fee to $200, then $300, and so on until people stop. The sensible, obvious solution is to just ban guns on planes. But that would be “arbitrary.”

* It is theoretically plausible that one should simply price the subsidies and externalities and then let the market determine whether big banks provide enough societal benefit to offset the costs they impose on the rest of us. But that is not what Stein, Tarullo, and Bernanke are saying.

The Cost of (Equity) Capital

By James Kwak

For years, the world’s largest banks have been up in arms over threats by regulators to increase their (equity) capital requirements. Making banks hold more capital, they argue, will force them to reduce lending and will increase their cost of funding, making credit more expensive throughout the economy. One of the chief defenders of the megabanks has been Josef Ackermann, CEO of Deutsche Bank until last year and also chair of the Institute of International Finance, which claimed that higher capital requirements would reduce economic output by a whopping 3.2 percent.

Anat Admati and Martin Hellwig have been tirelessly debunking the myth that higher capital levels will force banks to curtail lending and torpedo the global economy, most recently in their excellent new book, The Banker’s New Clothes. Some of the arguments against higher capital requirements are simply incoherent, like the idea that banks would be forced to set aside capital instead of lending it. (Capital is the difference between assets and liabilities, not cash that you put somewhere for safekeeping; were it not for reserve requirements, which are something else, a bank could lend out 100 percent of the money it can raise.) 

Some contradict basic principles of corporate finance, like the idea that adding more equity capital increases banks’ cost of funding.* Yes, equity is usually more expensive than debt (meaning that investors demand a higher expected rate of return) because it is riskier (the range of possible outcomes is greater). But as you add equity, both the debt and the equity become less risky (since the firm is less leveraged), which reduces the cost of debt and the cost of equity. According to Modigliani-Miller, the two effects balance out perfectly, given a few assumptions.

In the real world, debt has a tax advantage (interest on debt is tax-deductible, while cash that is paid to shareholders or reinvested in operations is not), so increasing debt can reduce the overall cost of financing. But that’s a government subsidy. Lower leverage might increase banks’ funding costs, but would reduce taxpayer subsidies; to a first approximation, this would make society better off, not worse off (since subsidies are distorting).

Ackermann’s old bank was one of the most insistent that higher capital requirements were bad and that having to issue new stock was bad. Last summer, one of his successors said, “The bank aims to apply all capital levers at its disposal before considering raising equity from investors.”

Well, until last week. That’s when Deutsche Bank raised almost €3 billion by selling new stock. And what happened? Its stock closed up 3.7 percent.** (The S&P 500 was up 0.7 percent.)

What does that mean? Well, the big banks would have you believe that equity is “expensive,” so forcing banks to to issue more equity is bad for them and will increase their funding costs (which they will pass on to the rest of us). In this case, however, Deutsche Bank’s shareholders clearly thought that selling new stock was a good thing, since it made the bank  more valuable. And it couldn’t possibly have raised the banks overall cost of capital (including both debt and equity): if you change your capital structure, your operations don’t change, and the value of your company goes up, that means that your cost of capital must have gone down. In other words, Deutsche Bank was leveraged past its optimal debt-to-equity ratio, even leaving aside societal considerations, so issuing new equity (raising capital, in banking parlance) was a good thing. It made both their debt and their equity less risky, reducing their cost of capital.

Of course, the big banks aren’t going to stop whining about capital requirements anytime soon. This is just further evidence that the global economy—and the banks themselves—would be just fine with more capital.

So who would be worse off? Well, anyone whose bonus is tied (asymmetrically) to return on equity, for starters.

* Unfortunately, “capital” means something different in the banking world than in the corporate finance world. In the former, capital is the difference between assets and liabilities, and is a rough synonym for equity—rough because, by regulation, some types of liabilities are counted as some types of capital. In corporate finance, capital refers to financing in general; the weighted average cost of capital, for example, includes the cost of both debt and equity.

** That was the 4 pm NYSE close, which came after the announcement of the stock sale, but before the bank reported earnings.

With Great Power . . .

By James Kwak

A friend brought to my attention another example of how Excel may actually be a precursor of Skynet, after the London Whale trade and the Reinhart-Rogoff controversy. This comes to us in a research note from several years ago by several bioinformatics researchers titled “Mistaken Identifiers: Gene name errors can be introduced inadvertently when using Excel in bioinformatics.” The problem is that various genes have names like “DEC1″ or identifiers like “2310009E13.” When you important those text strings into Excel, by default, the former is converted into a date and the later is converted into scientific notation (2.310009 x 10^13). Since dates in Excel are really numbers behind the scenes (beginning with January 1, 1900), those text identifiers have been irretrievably converted into numbers.

This problem is related to what makes Excel so popular: it’s powerful, intuitive, and easy to use. In this case, it is guessing at what you really mean when you give it data in a certain format, and most of the time it’s right—which saves you the trouble of manually parsing text strings and converting them into dates (which you can do using various Excel functions, if you know how). But the price of that convenience is that it also makes it very easy to make mistakes, if you don’t know what you’re doing or you’re not extremely careful.

There are workarounds to this problem, but as of 2004, it had infected several public databases. As the authors write, “There is no way to know how many times and in how many laboratories the default date and floating point conversions to non-gene names have adversely affected an experiment or caused genes to ‘disappear’ from view.”

Can You Say “Bubble”?

By James Kwak

Yesterday’s Wall Street Journal had an article titled “Foosball over Finance” about how people in finance have been switching to technology startups, for all the predictable reasons: The long hours in finance. “Technology is collaborative. In finance, it’s the opposite.” “The prospect of ‘building something new.’” Jeans. Foosball tables. Or, in the most un-self-conscious, over-engineered, revealing turn of phrase: “The opportunity of my generation did not seem to be in finance.”

We have seen this before. Remember Startup.com? That film documented the travails of a banker who left Goldman to start an online company that would revolutionize the delivery of local government services. It failed, but not before burning through tens of millions of dollars of funding. There was a time, right around 1999, when every second-year associate wanted to bail out of Wall Street and work for an Internet company.

The things that differentiate technology from banking are always the same: the hours (they’re not quite as bad), the work environment, “building something new,” the dress code, and so on. They haven’t changed in the last few years. The only thing that changes are the relative prospects of working in the two industries—or, more importantly, perceptions of those relative prospects.

Wall Street has always attracted a particular kind of person: ambitious but unfocused, interested in success more than any achievements in particular, convinced (not entirely without reason) that they can do anything, and motivated by money largely as a signifier of personal distinction. If those people want to work for technology startups, that means two things. First, they think they can amass more of the tokens of success in technology than in finance.

Second—since these are the some of the most conservative, trend-following people that exist—it means they’re buying at the top.

Yet Another Proposal To Raise My Own Taxes

By James Kwak

In chapter 7 of White House Burning, we proposed to eliminate or scale back a number of tax breaks that I benefit from directly, including the employer health care exclusion, the deduction for charitable contributions, and, most importantly, tax preferences for investment income. We did not, however, go after tax breaks for retirement savings, on the grounds that Americans already don’t save enough for retirement.

Well, in my latest Atlantic column, I’m going after that one, too. I changed my mind in part for the usual reason—the dollar value of tax expenditures is heavily skewed toward the rich. But the other reason is that the evidence indicates that this particular subsidy doesn’t even do what it’s supposed to do: increase retirement savings. Instead, we should take at least some of the money we currently waste on tax preferences for 401(k)s and IRAs and use to shore up Social Security, the one part of the retirement “system” that actually works for ordinary Americans.

Of course, this isn’t going to happen anytime soon. President Obama proposed capping tax-advantaged retirement accounts at $3.4 million, which is a step in the right direction. ($150,000 would be a better limit, since most people reach retirement with far less in their 401(k) accounts.)* But even that was attacked by the asset management industry as theft from the elderly.

* Yes, I know about the issue of small business owners who only set up accounts for their employees because they want to benefit from them themselves. It’s a red herring. First, if an employer doesn’t have a 401(k), employees can contribute $5,000 to an IRA—and $5,000 is a lot more than most middle-income, small business employees are currently contributing. Second, the right solution would be to default everyone into a retirement savings account instead of relying on employers to decide whether or not to set up 401(k) plans.

Frat Boys and Tech Companies

By James Kwak

Matt Bai’s recent article on how Curt Shilling’s gaming company, 38 Studios, managed to secure a $75 million loan from the State of Rhode Island and then flame out into bankruptcy is a reasonably fun read. Bai’s main emphasis, which I don’t disagree with, is on Rhode Island’s Economic Development Corporation, which managed to invest all of its capital in a single company in a risky industry that, apparently, had failed to secure funding from any of the VC firms in the Boston area. Overall, this seems like another example of why government agencies shouldn’t be trying to act like lead investors.

But the story has another moral, which struck closer to home for me. Shilling apparently founded the company because he liked MMORPGs and because he wanted to become “Bill Gates-rich.” When the going got tough, in Bai’s words, Shilling “seemed to think that he could will Amalur into being, in the same way he had always been able to pitch his way out of a bases-loaded jam, even with a throbbing arm. His certainty reassured employees on Empire Street, who had no idea that he was running out of money.”

Software is hard. Really hard. And it’s even harder when you’re up against good competition. It has to be done right, and you cannot get it done twice as fast by working “twice” as hard. Too many software companies have been run into the ground by people who wanted to make a fortune but had no understanding of how software is built. Most of them are back-slapping frat boys who climbed the corporate hierarchy in sales, not world-famous athletes. But Curt Shilling, apparently, was just like them.

Protecting Boards from Their Own Shareholders

By James Kwak

I teach corporate law, and one of the topics in a typical introductory corporate law course is hostile takeovers. The central legal question is: to what extent is a board of directors allowed to undertake defenses against a takeover bid, even if (as is always the case) the potential acquirer is offering a premium over the current market price?

Whenever I teach one of these cases, I always bring up the nagging economic question: if the share price is $20, and Big Bad Raider is offering $30 in cash to each and every shareholder, where does the board get the chutzpah to claim that, under its leadership, the true value of the company is more than $30? (I understand the argument that Bigger Badder Raider might be convinced to pay more than $30, but the law, at least in Delaware, allows boards to use some takeover defenses to fend off any acquirer.) This always baffles me, but the law is premised on the idea that there is some fundamental value that is hidden deep inside the current board’s “strategic plans,” and that Big Bad Raider may rob shareholders of this fundamental value.

One of the intellectual rationales for takeover defenses, as for several other devices that insulate current boards from the outside world (such as staggered boards) is the idea that too much shareholder pressure can cause corporations to make decisions that are good in the short term but bad in the long term. Again, this raises the question of why board members (or the lawyers and academics who support them) should be trusted when they say that policy X, even though it increases the stock price in the short term, is really bad in the long term. The short-term price increase can only occur if the market, in aggregate, believes that policy X is good for the company in the long term. So, in essence, board members are claiming that they are smarter than the market. Yes, the market makes mistakes (I’m no believer in perfect efficiency), but you should rarely trust someone who claims to know when those mistakes occur.

In a new paper, Lucian Bebchuk attempts to dismantle “The Myth That Insulating Boards Serves Long-Term Value.” His argument come in at least three forms. The first is that even if it were true that shareholder pressure (whether actual shareholder activism, or board decisions taken because of the threat of shareholder activism) could produce decisions that are good in the short term and bad in the long term, this must be balanced against the other benefits of shareholder pressure. Activists will also favor decisions that are good in the short term and in the long term. Furthermore, shareholder pressure is what constrains managers who might otherwise use the corporation’s resources for their own ends—whether empire building, preparing campaigns for political office, or lavishly redecorating their executive suites.

The second is a review of empirical studies showing:

Shareholder activist campaigns produce increases in short-term stock prices
Those short-term increases are not reversed in the following five years
Those increases are not reversed even after the initial activist fund sells its holdings (meaning that the people it sells to are not harmed)
Activist campaigns result in improvements in operating performance over the next several years (often reversing previous declines)
Various measures of board insulation, including staggered boards, are associated with lower stock returns and operational performance

The third is Bebchuk’s observation that, in a world of investment vehicles seemingly catering to every taste, there are no funds that attempt to make money by systematically betting against shareholder activists and holding their positions for the long term. If activism were bad, you would think someone wuld be betting real money on that principle. Not only that, but the investment funds that do have a long-term horizon, such as CALPERS, have voted consistently against board insulation, and continue to do so.

None of this should be surprising. Even if it were possible for some clever hedge fund manager to pressure a company into doing things that are good in the short term but bad in the short term, what is the alternative? Without accountability to shareholders, why would we expect board members to serve any interests other than their own? The typical independent board member is the CEO or former CEO of some other company. His reputation depends on that company and a large chunk of his net worth is tied up in that company’s stock—not the company on whose board he sits. What penalty is there for being a director of a failing company? None. (See Rubin, Robert.) If we insulate boards from shareholder pressure, we are essentially counting on directors’ altruistic feelings toward shareholders. Hope is not a strategy.

But this myth will no doubt persist. Why? One reason is that, in academia (legal academia, at least), there is a market for entirely theoretical models that are devoid of any empirical support. More important, the myth of board insulation benefits corporations’ current directors and executives by freeing them to pursue their own interests.

Among the major supporters of board insulation are the U.S. Chamber of Commerce and the Business Roundtable. These organizations often hold themselves out as defenders of capitalism and free markets. But on this issue, it’s clear that they are not taking the side of corporations themselves or their shareholders. Instead, they are on the side of the select few who run those corporations. The ability of that privileged elite to mobilize corporate resources to protect themselves from their own shareholders is what ensures that the myth will persist.