̽��ֱ�� of Cambridge - corporate

Robots cause company profits to fall – at least at first

sc604 — Thu, 03 Aug 2023 10:05:12 +0000

̽��ֱ��researchers, from the ̽��ֱ�� of Cambridge, studied industry data from the UK and 24 other European countries between 1995 and 2017, and found that at low levels of adoption, robots have a negative effect on profit margins. But at higher levels of adoption, robots can help increase profits.

According to the researchers, this U-shaped phenomenon is due to the relationship between reducing costs, developing new processes and innovating new products. While many companies first adopt robotic technologies to decrease costs, this ‘process innovation’ can be easily copied by competitors, so at low levels of robot adoption, companies are focused on their competitors rather than on developing new products. However, as levels of adoption increase and robots are fully integrated into a company’s processes, the technologies can be used to increase revenue by innovating new products.

In other words, firms using robots are likely to focus initially on streamlining their processes before shifting their emphasis to product innovation, which gives them greater market power via the ability to differentiate from their competitors. ̽��ֱ��results are reported in the journal IEEE Transactions on Engineering Management.

Robots have been widely used in industry since the 1980s, especially in sectors where they can carry out physically demanding, repetitive tasks, such as automotive assembly. In the decades since, the rate of robot adoption has increased dramatically and consistently worldwide, and the development of precise, electrically controlled robots makes them particularly useful for high-value manufacturing applications requiring greater precision, such as electronics.

While robots have been shown to reliably raise labour productivity at an industry or country level, what has been less studied is how robots affect profit margins at a similar macro scale.

“If you look at how the introduction of computers affected productivity, you actually see a slowdown in productivity growth in the 1970s and early 1980s, before productivity starts to rise again, which it did until the financial crisis of 2008,” said co-author Professor Chander Velu from Cambridge’s Institute for Manufacturing. “It’s interesting that a tool meant to increase productivity had the opposite effect, at least at first. We wanted to know whether there is a similar pattern with robotics.”

“We wanted to know whether companies were using robots to improve processes within the firm, rather than improve the whole business model,” said co-author Dr Philip Chen. “Profit margin can be a useful way to analyse this.”

̽��ֱ��researchers examined industry-level data for 25 EU countries (including the UK, which was a member at the time) between 1995 and 2017. While the data did not drill down to the level of individual companies, the researchers were able to look at whole sectors, primarily in manufacturing where robots are commonly used.

̽��ֱ��researchers then obtained robotics data from the International Federation of Robotics (IFR) database. By comparing the two sets of data, they were able to analyse the effect of robotics on profit margins at a country level.

“Intuitively, we thought that more robotic technologies would lead to higher profit margins, but the fact that we see this U-shaped curve instead was surprising,” said Chen.

“Initially, firms are adopting robots to create a competitive advantage by lowering costs,” said Velu. “But process innovation is cheap to copy, and competitors will also adopt robots if it helps them make their products more cheaply. This then starts to squeeze margins and reduce profit margin.”

̽��ֱ��researchers then carried out a series of interviews with an American medical equipment manufacturer to study their experiences with robot adoption.

“We found that it’s not easy to adopt robotics into a business – it costs a lot of money to streamline and automate processes,” said Chen.

“When you start bringing more and more robots into your process, eventually you reach a point where your whole process needs to be redesigned from the bottom up,” said Velu. “It’s important that companies develop new processes at the same time as they’re incorporating robots, otherwise they will reach this same pinch point.”

̽��ֱ��researchers say that if companies want to reach the profitable side of the U-shaped curve more quickly, it’s important that the business model is adapted concurrently with robot adoption. Only after robots are fully integrated into the business model can companies fully use the power of robotics to develop new products, driving profits.

A related piece of work being led by the Institute for Manufacturing is a community programme to help small- and medium-sized enterprises (SMEEs) to adopt digital technologies including robotics in a low-cost, low-risk way. “Incremental and step changes in this area enable SMEs to get the benefits of cost reduction as well as margin improvements from new products,” said co-author Professor Duncan McFarlane.

̽��ֱ��research was supported by the Engineering and Physical Sciences Research Council (EPSRC) and the Economic and Social Research Council (ESRC), which are both part of UK Research and Innovation (UKRI). Chander Velu is a Fellow of Selwyn College, Cambridge. Duncan McFarlane is a Fellow of St John's College, Cambridge.

Reference:
Yifeng P Chen, Chander Velu, Duncan McFarlane. ‘ ̽��ֱ��Effect of Robot Adoption on Profit Margins.’ IEEE Transactions on Engineering Management (2023). DOI: 10.1109/TEM.2023.3260734

Researchers have found that robots can have a ‘U-shaped’ effect on profits: causing profit margins to fall at first, before eventually rising again.

It’s important that companies develop new processes at the same time as they’re incorporating robots, otherwise they will reach this same pinch point

Chander Velu

kynny via Getty Images

Robots on a manufacturing line

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Women are ‘running with leaded shoes’ when promoted at work, says study

Anonymous — Tue, 19 Apr 2022 07:13:24 +0000

Women and men feel different at work, as moving up the ranks alleviates negative feelings such as frustration less for women than for men, says a sweeping new study on gender differences in emotion at work.

̽��ֱ��study, led by researchers at Yale ̽��ֱ�� and co-authored by Jochen Menges at Cambridge Judge Business School, finds that rank is associated with greater emotional benefits for men than for women, and that women reported greater negative feelings than men across all ranks.

Because emotions are important for leadership, this puts women at a disadvantage akin to running with ‘leaded shoes’, according to the study, which is based on nearly 15,000 workers in the US.

̽��ֱ��results, published in Sex Roles: A Journal of Research, tie the different ways women and men experience emotions at work to underrepresentation at every level of workplace leadership.

Little previous research on gender and workplace emotions

̽��ֱ��study notes that, while the glass ceiling for women has been extensively documented, there has been surprisingly little research on gender differences in emotions at work. Understanding this is particularly important as emotions influence job performance, decision-making, creativity, absence, conflict resolution and leadership effectiveness.

̽��ֱ��practical implications of the study are that organisations must provide support to women as they advance, including formal mentoring relationships and networking groups that can provide opportunities to deal with emotions effectively while supporting women as they rise within organisational ranks.

“It would be hard for anyone to break through a glass ceiling when they feel overwhelmed, stressed, less respected and less confident,” said Menges, who teaches at both the ̽��ֱ�� of Zurich and Cambridge Judge Business School.

“This emotional burden may not only hamper promotion opportunities for women, but also prevent them from contributing to an organisation to the best of their ability. More needs to be done to level the playing field when it comes to emotional burdens at work,” said Menges, whose research often focuses on leadership, motivation and other workplace issues.

Women feel more ‘overwhelmed, stressed, frustrated’ at work

̽��ֱ��study finds gender does make a difference for the emotions that employees experience at work. Compared to men, women reported feeling more overwhelmed, stressed, frustrated, tense, and discouraged, and less respected and confident.

Women reported greater negative feelings than men across all ranks. Although these feelings decreased for both men and women as they moved up in rank, the extent to which rank diminished negative feelings differed between the sexes. For instance, moving up rank did alleviate frustration and discouragement in both men and women, but it did so more for men than for women.

̽��ֱ��study says that because women experience more negative and fewer positive feelings in climbing the organisational ladder, this puts women at a disadvantage in attaining leadership roles.

At the lowest levels of employment, women reported feeling significantly more respected than men, yet this reverses as people climb within an organisation, resulting in men feeling significantly more respected than women at higher levels.

̽��ֱ��research used data from 14,618 adult US workers (50.7% male, 49.3% female) reflecting a diversity of race, ethnicity and industries, to test the following factors:

--Differences in the emotions that men and women experience at work.

--If gender interacts with rank to predict emotions.

--Whether the association between gender and emotions is mediated by emotional labour demands.

--If this relationship differs as a function of the proportion of women in an industry or organisational rank.

Feelings ranging from ‘inspired’ to ‘stressed’

Emotions were assessed using two different methods. Participants used a sliding scale to indicate how often they had experienced 23 feelings at work in the previous three months. ̽��ֱ��items included ten positive emotions such as “interested”, “proud” and “inspired”, and 13 negative responses including “bored”, “stressed” and “envious”. Participants were also asked to report their typical feelings about work in open-ended responses about how their job had made them feel over the past six months.

In addition, to assess positional power, participants were asked to place themselves on a ladder with ten steps representing where people stand in their organisation.

Inhibiting negative emotion is not the answer

̽��ֱ��study concludes that simply smothering emotion in the workplace isn’t the answer: Inhibiting negative emotions for a prolonged time increases burnout, and negatively impacts performance and personal well-being.

It recognises there are areas of future research which include how gender interacts with other categories of identity, such as race and ethnicity, social class, and sexuality. Women of colour face stronger glass ceiling effects than white women and have to simultaneously navigate bias and discrimination based on their gender and race.

̽��ֱ��authors also suggest further investigation to establish whether women’s negative experiences can impose an emotional glass ceiling because obstacles such as unequal treatment at work causes emotions such as feeling disrespected, which in turn can become an additional barrier to advancement.

Reference:
Christa L. Taylor et al. ‘Gender and Emotions at Work: Organizational Rank Has Greater Emotional Benefits for Men than Women.’ Sex Roles (2022). DOI: 10.1007/s11199-021-01256-z

Adapted from a story on the Cambridge Judge Business School website.

Promotion at work has greater emotional benefit for men than women, says a new study on gender and workplace emotion.

Maskot

Colleagues sitting at conference table

̽��ֱ��text in this work is licensed under a Creative Commons Attribution 4.0 International License. Images, including our videos, are Copyright © ̽��ֱ�� of Cambridge and licensors/contributors as identified. All rights reserved. We make our image and video content available in a number of ways – as here, on our main website under its Terms and conditions, and on a range of channels including social media that permit your use and sharing of our content under their respective Terms.

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Fighting board rubber-stamping

sc604 — Tue, 14 Jul 2015 07:00:00 +0000

Public companies should appoint a ‘Contrarian Director’ who systematically challenges management recommendations to the board and suggests a range of alternative outcomes, argues a Cambridge graduate student in recently published research.

A Contrarian Director (CD) would help prevent rubber-stamping of management decisions by too-collegial boards whose supposedly “independent” directors are anything but, according to MBA student Siobhan Sweeney. Her paper cites last year’s comment by Warren Buffett that companies recruiting such directors often “do not look for Dobermans. They look for Cocker Spaniels and then they make sure their tails are wagging.”

According to Sweeney, there have been “significant failings of boards,” as shown by the recent financial crisis and other corporate failings.

Currently, “social and psychological incentives propel directors towards collegial consensus,” and acting as a devil’s advocate in the boardroom is “currently a dangerous career path.” So appointing a CD to every public company board is an “innovative solution that is simple yet has the ability to significantly increase the board’s ability to discharge their corporate governance and risk oversight.”

̽��ֱ��CD concept was inspired by the Catholic Church’s ‘Devil’s Advocate,’ introduced in 1587 to argue against a candidate’s canonisation in order to uncover any character flaws, but modelled more on the Advocate General of the European Union, who delivers impartial recommendations to the full EU Court of Justice.

̽��ֱ��CD’s role would be more impartial than that of the church’s Devil’s Advocate: while both present a negative hypothesis, the CD’s proposed role is then to “assess the strength of the negative hypothesis to assist the board to form a balanced opinion.”

̽��ֱ��CD’s name derives from the literal Greek translation of ‘contrarian,’ who “habitually opposes or rejects prevailing opinion or established practice” – and in the context of the CD provides significant recommendations to the board.

Under the paper’s proposal, companies would adopt their charters to state that a CD appointed to their board “has a duty in respect of every recommendation to the board of substance to give careful consideration to the possible case, if any, against the recommendation. ̽��ֱ��CD must then prepare for the Board a written report, which outlines the case or possible case against the recommendation. ̽��ֱ��written opinion of the CD would be non-binding on the board and CEO.”

To help companies choose CDs, a new Institute of Contrarian Directors would be established in order to maintain a list of qualified CDs – people with analytical skills and experience, but who have not previously served as public company directors except as a CD. If a company asks the Institute to suggest a CD, and the company does not make the appointment, the Institute would not make a further CD suggestion to that company for five years to prevent the company “shopping for an amenable CD.”

“ ̽��ֱ��introduction of the CD institutionalises the ability to stand outside the tide of Groupthink and effectively warn and caution the board,” said Sweeney, who was a corporate lawyer in Australia before beginning the Cambridge MBA programme last year.

Sweeney’s paper, ‘ ̽��ֱ��creation of the Contrarian Director and their role in achieving workable board independence and better risk oversight’, was recently named the winner of the 2015 Cambridge-McKinsey Risk Prize at the Centre for Risk Studies at ̽��ֱ�� of Cambridge Judge Business School.

̽��ֱ��award, in conjunction with consulting firm McKinsey & Company, was announced at the recent 6th annual Risk Summit of the Cambridge Centre for Risk Studies at Cambridge Judge. ̽��ֱ��award is open to current students at Cambridge Judge.

“ ̽��ֱ��judges were particularly impressed by the originality and spark of Siobhan Sweeney’s proposal on contrarian directors, which speaks directly and practically to corporate governance,” said Danny Ralph, Professor of Operations Research and Academic Director of the Centre for Risk Studies at Cambridge Judge. ̽��ֱ��judges, who consulted with other risk professionals and academics, were Professor Ralph and Dr Sven Heiligtag, a principal at McKinsey’s global risk practice based in Hamburg.

Adapted from an article originally published on the Cambridge Judge Business School website.

Public companies should appoint a ‘Contrarian Director’ – inspired by the ‘Devil’s Advocate’ – to challenge board decisions and suggest alternatives, according to new Cambridge research.

Social and psychological incentives propel directors towards collegial consensus

Siobhan Sweeney

Matt Wells

Devil's Advocate

̽��ֱ��text in this work is licensed under a Creative Commons Attribution 4.0 International License. For image use please see separate credits above.

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̽��ֱ��intoxication of power

tdk25 — Wed, 18 Sep 2013 08:46:23 +0000

They say that pride comes before a fall, but in business, it also often triggers the collapse. History is littered with examples of corporate giants who were, according to subsequent post-mortems, felled by bad decision-making, brought on by excessive self-confidence, arrogance, and pride. In the final analysis, the word “hubris” crops up again and again.

Now board directors and senior managers from around the country are being invited to find out why. A conference in Cambridge this week will explore the perennial problem of hubris in leadership, and attempt to offer some tips designed to school the participants out of repeating others’ past mistakes.

Entitled “ ̽��ֱ��Intoxication Of Power: Leadership and Hubris”, the event will involve presentations from experts in business, management and academia, all of whom have examined what it is about leadership that distorts a person’s thinking and character, inflates their ego, and frequently causes them to make rash and damaging decisions as a result.

It will include analysis of the relationship between senior executives, and the mechanics of sycophancy in the workplace. There will also be a presentation of psychological research which suggests that humans may be hard-wired to make dubious decisions about the future, and that CEOs could learn a thing or two from crows, which are much better at forward planning.

In addition, there will be a workshop inviting the participants to contemplate and discuss the implications of hubris both for their companies and for themselves.

̽��ֱ��conference, on Thursday, 19 September, is being organised by Cambridge Judge Business School - part of the ̽��ֱ�� of Cambridge - and the Daedalus Trust. ̽��ֱ��latter is dedicated to the cause of trying to understand problems of hubris, and was set up “to raise awareness and understanding of the changes in individuals, groups and whole organisations that can come with the exercise of power”.

“Hubris is not a mental disease - it is the result of psychological reactions to power and status to which we are all subject,” Professor Christoph Loch, Director of Cambridge Judge Business School said.

“In healthy people, it serves to enable confidence and reduce stress, but in some, it creates a perception of oneself as a giant and others as minions. This distorts the individual’s sense of goals and decisions. It’s this effect that makes hubris a highly relevant risk-management issue for businesses.”

̽��ֱ��decline of numerous companies has been attributed to moments when those responsible for leading the firm began to make poor judgements based on previous successes, with the result that they failed to respond to changes in the market and fell behind their rivals.

̽��ֱ��Cambridge event will attempt to show participants how to assess themselves and their colleagues to make sure that their own companies do not suffer from the same causes and effects. It will also examine how business leaders can harness the energies and passions of their staff, without at the same time allowing a culture of hubris to develop.

Speakers will include the former British Foreign Secretary, Lord David Owen, who has authored a book on ̽��ֱ��Hubris Syndrome; Martin Taylor, former chairman of Syngenta AG and former CEO of Barclays Bank; Professor Manfred Kets de Vries, an authority on leadership development; and Professor Nicola Clayton and Clive Wilkins, from the Department of Psychology at Cambridge.

De Vries argues that hubris starts to lead companies astray when senior executives stop recognising that many of their subordinates are lying to them - even if they don’t realise it. Most corporate leaders, he suggests, are surrounded by people who tell them what they want to hear. ̽��ֱ��danger occurs when they start to believe in this, and to enjoy it.

This breeds more than a sycophantic culture - in some cases, “intoxication and intimidation go hand in hand”. “Subordinates become intimidated by the power of office and leaders become the vessels of their projected fantasies,” de Vries’ synopsis for the conference says. ̽��ֱ��accoutrements of this are things like “large, impressive offices, chauffeur-driven cars, private jets, fawning secretaries - all adding to a climate of awe that surrounds many leaders. Power leads to dependency reactions, and even physical illness in others. Many top executives don’t realise, however, the extent to which people project their fantasies on to them.”

Nicola Clayton, Professor of Comparative Cognition, and Clive Wilkins, who is currently artist in residence, both in the Department of Psychology at Cambridge ̽��ֱ��, meanwhile offers an intriguing take on the relationship between hubris and the human brain’s capacity - or lack of it - to plan ahead. Their presentation will argue that our brains suffer from a natural short-sightedness about the projection of self in time, which makes envisaging the future rather difficult.

̽��ֱ��phenomenon is referred to as “temporal myopia”. “We assume that what we feel as we imagine the future is what we will experience when we get there,” Clayton and Wilkins explained. “In fact, our sensations as we imagine it are often our response to what is happening right now.”

If we want to find a way to get round this hard-wiring, the unlikely subject of crows might just offer some answers. Surprisingly, crows do not succumb to the same failings. Clayton and colleagues have studied how these birds hide food for the future, and her research shows that they can anticipate accurately what they will want when they come to recover it in the future.

In other words, crows appear to be more capable of disengaging from their present motivational state when choosing for what may lie ahead. “It’s a skill that every CEO in the land ought to have,” Clayton and Wilkins added.

̽��ֱ��Intoxication Of Power - Leadership And Hubris, will run at Judge Business School, Cambridge, on Thursday, 19 September, 2013. For further information, visit www.jbs.cam.ac.uk/insight/2013/the-intoxication-of-power-leadership-hubris.

For more information about this story, please contact Tom Kirk, Tel: +44 (0)1223 332300, thomas.kirk@admin.cam.ac.uk

Why are so many companies brought down by an excess of self-confidence, and rash decision-making by out-of-control egos at the top? A Cambridge conference aims to explain why power corrupts, and whether corporate leaders could learn a few lessons from the humble crow.

Hubris creates a perception of oneself as a giant and others as minions. This distorts the individual’s sense of goals and decisions.

Christoph Loch

01228 by Victor 1558 from Flickr

̽��ֱ��conference will examine the effects that the projected fantasies of subordinates have on managers when the latter begin to believe in them.

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Fraud claims and board games: What now for regulation and governance?

bjb42 — Thu, 02 Aug 2012 07:57:04 +0000

Sir Adrian Cadbury is one of a number of distinguished experts who will be speaking at the 4th Cambridge International Regulation and Governance Conference on 6 September. Booking details can be found at www.anglia.ac.uk/reggovconference

Under the banner, "More regulation, or better stewardship?" the conference will ask how far the global financial crisis has posed a challenge to existing systems of governance and regulation and where they should go from here.

Current reviews, both in the UK and Europe, have suggested that poor governance of major companies was one of the reasons behind the economic failure which began in 2008. Some reforms to the way in which these companies are controlled and regulated have already taken place, but as the Libor-fixing scandal suggests, big questions about governance remain.

̽��ֱ��aim of the conference, which is being jointly hosted by the ̽��ֱ�� of Cambridge and Anglia Ruskin ̽��ֱ��, is to encourage the exchange of ideas about these issues between practitioners specialising in governance and regulation, policy-makers and academics.

"As we examine the mistakes of the past and look to the future we need to think carefully about how our companies and banks should be governed," Dr Paul Sanderson, a specialist in regulation at the ̽��ֱ�� of Cambridge and one of the conference organisers, said. "Essentially the question is do we want more rules, which could potentially stifle innovation and growth, or better stewarding of what are, after all, our assets?"

Sir Adrian Cadbury, who is also a ̽��ֱ�� of Cambridge alumnus, will address the conference on the 20th anniversary of his landmark contribution to the field, the "Report of the Committee on the Financial Aspects of Corporate Governance." ̽��ֱ��publication of this report led to the first code of corporate governance being established as a requirement for a listing on the London Stock Exchange and ultimately to the current UK Corporate Governance Code and numerous such codes around the world.

These lay down basic principles on matters such as the separation of the roles of Chairmen and CEOs, the appointment of non-executive directors to boards, the responsibilities of board members and indeed shareholders, and how decisions should be made about senior executives' pay.

But, constructing a universal template - a set of rules that can be applied to all types and sizes of companies on all occasions - is almost impossible. Cadbury cleverly incorporated into the code the comply-or-explain principle to deal with this. It allows companies to explain to their stakeholders when they have not fully conformed to the rules. It is then a matter primarily for shareholders to consider whether such action is justified and react accordingly.

Some explanations may be considered unacceptable, where a powerful figure fails to convince shareholders of the need to combine the roles of Chairman and CEO. In other cases non-compliance may be unavoidable, such as the inability of a director to attend the requisite number of board or committee meetings through illness, or even death.

In addition, while in theory the rules reflect best practice, best practice is also something which evolves. So non-compliance by a company may simply mean, in some cases, that the company has followed best practice and the code itself needs revising.

̽��ֱ��difficulties in determining the extent to which rules should be operated flexibly in codes of corporate governance is mirrored in the regulation of many other sectors, such as financial services, health and safety, hospitals, railways and so on. Failure inevitably and rightly leads to calls for better regulation, which often means that the rules become less flexible and enforcement measures become stronger.

Yet this action, while it may prevent some future failures, may also prevent innovation - the development of new products and services that would benefit us all. Getting the balance right is difficult - but clearly something has gone wrong, or we would not be suffering an economic downturn, with banks needing bailouts and GDP in many countries more or less stagnant.

This suggests that, as the Leveson Inquiry in the UK has hinted, we need to examine the culture of organisations. Most public companies are, as the name suggests, owned by the public one way or another, through pensions, insurance or savings plans. It is possible that greater emphasis is needed on protecting our assets, by implementing measures which ensure companies in whom we and large institutional shareholders invest adopt the practices and ethos of the very best.

These complex issues will be the subject of more than 40 papers which will be presented by experts from around the world at the conference on 6 September.

̽��ֱ��10 plenary and parallel sessions focus on topics such as corporate governance, regulation and ownership, board composition, executive pay and regulating the financial sector. In addition, the directors of two companies founded more than 400 years ago will speak on how to manage companies in the long run. To set the scene, Philip Augar, author of “ ̽��ֱ��Death of Gentlemanly Capitalism” will speak at the pre-conference dinner at Queens College, on 5 September.

Further information about the conference can be found here

̽��ֱ��author of the report which laid the basis for British and international corporate governance codes will be the guest speaker at a conference which asks what the future of such measures should be.

As we examine the mistakes of the past and look to the future we need to think carefully about how our companies and banks should be governed.

Paul Sanderson

SEIU.

Banking Protest.

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̽��ֱ��crisis of shareholder primacy

bjb42 — Mon, 19 Mar 2012 15:44:21 +0000

How do we prevent another financial crisis? Since the devastation that began with the collapse of the U.S. subprime mortgage market in 2007, a great deal of ink has been spilled trying to answer this question.

Unfortunately, most official accounts of the crisis, and how to avoid the next one, have missed the mark. They have overlooked the fundamental problem: a corporate governance model that the puts the private interest ahead of the public interest.

Financial institutions in most countries today are governed based on the theory of shareholder primacy. According this model, the institution’s management has one overriding duty: to maximize shareholder returns. True to its name, shareholder primacy puts shareholders in the driver’s seat; they get to choose the people who will run the financial institution for their benefit alone.

There are good reasons for supporting shareholder primacy. It is based on a healthy distrust of managers, who may be tempted to use the firm’s resources to pursue their own interests, rather than those of shareholders. Asking managers to balance the concerns of a number of different constituencies is just a license for them to abuse their power.

As a result, shareholder primacy tries to remove any ambiguity by making managers beholden to a single group – the firm’s shareholders. In addition to imposing legal obligations on directors and officers, today’s dominant corporate governance regime ties executive compensation to the share price. All of this is designed to align the interests of shareholders and managers.

In theory, this makes sense, but in practice it’s a recipe for crisis, specifically in the context of financial institutions. ̽��ֱ��business model of financial institutions is very different from that of an ordinary firm.

Basically, financial institutions profit from the “spread” between short- and long-term interest rates. In other words, they make money by lending at higher rates than they borrow. Thus, the best way for a bank to increase its profits is by increasing its “leverage” – that is, by making as many loans as possible.

But the greater the bank’s leverage, the greater its risks. This is because if the bank’s debtors begin to default, or if there’s a perception that they might, the bank’s creditors (its depositors) will come running for their money all at once; hence the expression “bank run”. During a run, the “mismatch” between the bank’s assets and liabilities leaves it strapped for cash, and can ultimately lead to insolvency and failure. This is precisely what happened to the likes of Northern Rock just a few years ago.

What does all this have to do with shareholder primacy? Since shareholders are interested in maximizing profit, they will encourage the financial institution, through its managers, to increase leverage. Given the legal obligations and financial incentives facing mangers today, they will likely oblige. If they don’t, the capital markets may see the firm as “undervalued”, making it a target for a hostile takeover bid, which, if accepted, will result in the management team being replaced by a more shareholder-friendly one.

Therefore, in a world where shareholders rule, the pressure on managers to satisfy the thirst for leverage and profit is tremendous.

We have known for decades, thanks to economists like John Maynard Keynes and Hyman Minksky, that financial institutions’ propensity for risk-taking is a key driver of economic instability. In order to maximize profit, banks look to progressively riskier assets, putting their faith in so-called “financial innovations”, which promise all the benefits of leverage without any of the risks.

For a time, rising asset prices validate bankers’ optimism, but eventually the bubble bursts, exposing it as nothing less than delusional. In the recent crisis, the innovations of choice were based on a method called securitisation, which in theory is supposed to distribute risk efficiently. In practice, however, securitisation turned out to be a “weapon of mass destruction”, as legendary American investor Warren Buffett put it.

̽��ֱ��methods were new this time, but the pattern of behaviour was anything but. In the last five decades, we have seen repeated crises of this kind, albeit not of this magnitude. So why don’t we learn from history? Why don’t we heed the warnings?

̽��ֱ��ideology of shareholder primacy has a lot to do with it. To begin with, during the boom, when shareholders are getting rich, the system makes it almost impossible for managers to buck the trend.

In addition, managers are not only expected to pursue shareholders’ economic interests, but their political ones as well. Not surprisingly, therefore, the financial industry is notorious for its lobbying activity. In the 1980s, the City of London pushed for the deregulation of the financial system. At the time, the reforms were dubbed the “Big Bang” due to the explosion in the capital markets that ensued; today the moniker is still appropriate, but for entirely different reasons…

As a result, those who would leave shareholder primacy in place and put their faith in regulation to stop the next crisis are mistaken. They do not account for the financial industry’s political influence, which has been used to weaken regulation or “capture” those who enforce it. And they are overconfident about the ability of regulators, regardless of their resources and independence, to keep up with financial innovation, especially given the unprecedented complexity and global scale of today’s financial system.

While stricter regulation – particularly with respect to capital requirements – is crucial, such reforms risk being undermined by the perverse incentives of shareholder primacy. A situation in which the regulatory system is butting heads with the corporate governance system is incoherent and unlikely to promote economic stability in the long term.

A final problem with shareholder primacy is that it results in the wrong kinds of people being appointed to serve as directors and officers of financial institutions. ̽��ֱ��skills and temperament that maximize shareholder profits conflict with those that promote economic stability. As a result, shareholders prefer dealmakers to caretakers.

True, directors and officers of financial institutions must pass the Financial Services Authority’s “fit and proper” test. But, as Lord Turner concluded in his review of financial regulation in the UK, these standards were poorly enforced in the years leading up to the crisis. This is because it was assumed – consistent with shareholder primacy – that financial institutions themselves were better placed to decide who should manage them. Not surprisingly, most bank executives didn’t understand the risks they were taking; some didn’t even have prior financial industry experience.

In order to prevent the next crisis, we need to do away with shareholder primacy for financial institutions, which are a special kind of company. We need a new corporate governance model that recognizes the essential role that financial institutions play in the wider economy and society. This means, at the very least, that their managers must have a legal duty to consider the public interest, and have the knowledge and temperament to discharge it accordingly.

If we want to prevent the next financial crisis, a new model of corporate governance is needed to replace shareholder primacy in financial institutions. Gates Scholar Mike Marin explains why.

In a world where shareholders rule, the pressure on managers to satisfy the thirst for leverage and profit is tremendous.

Mike Marin.

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