21

Stakeholder Capitalism

Will Hutton

Keynes famously called for the socialisation of investment at the end of his General Theory, and many critics of the British financial system have echoed that call. But the task is a more subtle one, if the object of the exercise is to keep the merits of private ownership while reshaping the way it works. Thus the great challenge of the twentieth century, after the experience of both state socialism and of unfettered free markets, is to create a new financial architecture in which private decisions produce a less degenerate capitalism. The triple requirement is to broaden the area of stake-holding in companies and institutions, so creating a greater bias to longterm commitment from owners; to extend the supply of cheap, longterm debt; and to decentralise decision-making. The financial system, in short, needs to be comprehensively republicanised.

The first breach would be made by establishing a republican-style central bank which understood that its role was to recast the financial system as a servant of business rather than as its master. Financial freedom would no longer be taken as axiomatically good but as a privilege which has to be earned, and which carries obligations. As matters stand the current Bank of England is a permanent obstacle to financial reform: a precondition for any wider reconstruction of the financial system is a transformation of its constitution, mission and values.

The Bank's structure would match the new federal structure of the state. As the country began to be organised politically around its constituent regions, nations and cities, there would be a framework of regional public banks reporting to the Central Bank, whose chief executives would be appointed by the elected parliaments of the appropriate region. They would sit on the governing board of the Bank, replacing the current Court (which is staffed by placemen of the rentier state) and deliberate over monetary policy and the wider reform of the financial system. The extent to which the Bank had the final word over interest rates or the extent to which it fell to the Chancellor of the Exchequer could be decided after the new arrangements had bedded down for at least one complete economic cycle and the character of the Bank became clearer. If it became a social partner in the republican sense, running monetary policy impartially with a democratic awareness of the trade-offs between lost output and lower inflation, the presumption would be that it would gain independence along US lines. With new constitutional arrangements there would, finally, be a way of ensuring its democratic accountability.

In its conduct of monetary policy the Bank would be armed with a more complete array of financial instruments than short-term interest rates. Instead of conceding the financial institutions' argument that their balance sheets are their own concern and that the only legitimate tool of policy is the price of money, the Bank would have the power to influence directly the structure and profitability of banking business in pursuit of its wider public objectives. It would, for example, reintroduce reserve requirements to support its interest rate policy, and it would follow the Bundesbank and the Federal Reserve by regulating the markets in a wider public interest than that defined by the markets themselves.

One of the Bank's chief preoccupations would be to lower the cost of capital in Britain – the combination of servicing of bank debt and shareholders' funds – and to lengthen the payback periods that companies set for their investment projects. This is the core of the British supply-side problem and the single most important explanation for indifferent levels of investment. British companies need to borrow more long-term debt and lower their target rates of return from new investment. The Bank's objective, along with a reformed Treasury, must be to construct a financial system in which this can take place; the first time the British authorities will have played such a role since the Industrial Revolution.

In order for companies to borrow more, the banks have to lend funds that companies can afford to service. In the same way that purchasing a house on a three-year mortgage with a 20 per cent interest rate would mean that fewer houses would be bought, so very few companies can sustain high investment with three-year paybacks and 20 per cent nominal returns. The first task, then, is to change the conditions that give British clearing banks their short-term, anti-industrial lending policies.

But for the banks to lend longer term, they themselves need less demanding financial criteria because long-term loans are less profitable for them than short-term revolving credits. They need to have their own cost of capital lowered; they need access to long-term deposits; and they need better credit assessment techniques, with incentives to develop closer relationships with their industrial customers in order better to judge the viability of their investment proposals.

Britain should copy other industrialised countries and create a public agency that will act as a financial intermediary collecting longer term deposits and channelling them to lending institutions. The Japanese use their post office network to collect long-term savings, and their great public investment banks then lend directly or in partnership with Japan's commercial banks. The US has deployed their federal housing finance intermediaries, “Fannie Mae” (Federal National Mortgage Association) and “Freddie Mac” (Federal Home Loan Mortgage Corporation), to encourage direct and indirect long-term finance for home purchase and new home construction; while Germany has its Kreditanstalt für Wiederaufbau (the KfW or Bank for Reconstruction) which makes long-term loans in partnership with the commercial banks and a network of regional development banks. The UK has nothing.¹

What it could have are regional banks collecting long-term deposits to recycle to clearing banks and other specialist lending institutions, like a housing bank to cater for housing associations, local authorities and the construction industry. A new benchmark for long-term bank lending would be established as more long-term bank loans were made. A specialist bank lending to small and medium-sized companies could support the same drive. In order to encourage long-term lending, the reformed Central Bank could offer assistance on favourable terms in the money markets to all longterm lenders – public and commercial banks alike. This would reassure them about the liquidity risk they were running.

But the banks are not charities and to entrench this new attitude the target rate of return on their own capital will have to be lowered. The Germans have two key mechanisms. First they exploit the stakeholder culture engendered by co-operative capitalism to lower the cost of capital for all enterprises, banks included. Shares are tokens of a long-term relationship rather than a trading asset, so that dividend payments can be lower and payback periods lengthened. Second, public banks at both state and regional level are constrained in their dividend distributions; profits build up as reserves and balance sheets are strengthened which gives a stable platform from which to lend long-term at keen rates of interest.

The combination is a potent one. Borrowers' loan packages, a mix of public and private loans, are cheaper because the private and public banks themselves need to earn lower financial returns. Nor do the commercial banks complain about this “subsidised” finance, as their counterparts in Britain might be expected to do. As they are themselves shareholders in the borrowing companies, they benefit from the impact that cheaper loan finance has on the borrowers' trading prospects.

To lower the cost of capital, British banks and their customers need more patient, committed shareholders and less of a hunger for dividends. The entire system could then move into a virtuous circle in which more long-term bank lending was validated by improved economic performance resulting from higher investment. Lowering the cost of capital would also allow the banks to invest more in internal systems for information gathering and credit assessment; these are expensive and time consuming, but would help the banks avoid the lending mistakes they made in the 1980s boom. If, at the same time, they could share in the success of the companies in which they invested the rewards for lending would be higher.

One immediate move would be to insist that banks take equity stakes in enterprises, and that banks which did not do so would rank lower in claims on firms' assets than stakeholding banks. The banks' legal capacity to take a “floating charge” on all of a company's assets should be abolished; this makes companies the prisoners of a single bank loan, prevents them from borrowing heavily to finance investment and encourages banks to look for property collateral to support their lending rather than offering finance for specific projects. It worsens the present disastrous arm's-length arrangements. A proper system of loan guarantees, run by a public institution, should be set up, allowing small firms in particular to borrow more aggressively. If these measures were combined with a legal requirement to regionalise the operations of the clearing banks, they would add up to a novel and important contribution to the creation of a British Mittelstand sector. Britain's small and medium-sized companies are damaged most by their inability to sustain high levels of long-term debt.

Perhaps, in the short run, bank dividends should be regulated and banks encouraged to build up cheaper internal reserves of capital. Banks will complain bitterly about any infringement of their “freedom”, but since the state is required to bail them out if they get into financial difficulties and to carry the wider social costs of their anti-industrial lending policies, such an initiative would create a proper symmetry of obligations.

The most important factor in reducing the cost of capital for banks and business generally is shareholder commitment. This should be fostered by exploiting the proposed new system of corporate governance and the role of non-executive directors, for banks and business alike. Groups of core institutional shareholders might be formed who would be represented on company and bank boards by non-executive directors with their own, information-gathering secretariats. Voting rights might be limited only to those shareholders who are represented on company boards, thus legally linking ownership with obligations to commitment. It might even be useful to split the functions of the supervisory and executive boards, as in Germany, with representatives of the core voting shareholders joining the supervisory board. They would engage in an ongoing dialogue with management about business strategy, with share options and bonuses only exercisable after a specified minimum period – say ten years' service – and with tax incentives for those who exercised options later. The current incentives for paper entrepreneurship, unlocking so-called shareholder value by asset manipulation and so boosting executives' share options, would be reduced. There would be a penal short-term capital gains tax for shareholders who took early profits, tapering to near zero for long-term shareholders. This would encourage shareholders to value future returns more highly than they do and so help companies to extend their payback periods.

This would only work if takeovers were made harder to mount. The tightening of lax accounting standards, setting new upper limits for advisers' fees (in particular removing their tax-deductibility) and allowing firms a “publicinterest” defence against hostile takeovers would all help. In addition the current obligation for any single shareholder to make a full bid if more than 30 per cent of the company is owned could be dropped. Large single shareholders can be sources of much needed stability. Although current doctrine is that effective stewardship of company assets requires the fear of takeover, this militates against the construction of long-term relationships within the company. Much of the so-called “shareholder value” that is “unlocked” by takeover amounts to no more than unravelling co-operative and committed relationships, which are priced above market-clearing levels, and reorganising them in a strictly price-mediated relationship. This lowers the company's variable costs which, taken together with the accountants' treatment of the financing costs of takeover, appears to make the acquisition profitable. But accounting fiddles are no route to industrial success, as Britain has discovered.

The approach to takeovers highlights another aspect of a properly constitutional democratic state – the role of audit. Without impartially prepared accounts that follow a transparent set of rules, the balance sheets and profits of firms are the playthings of private boards and their accountants. In their increasing anxiety to win business, accountants have been willing to bend accounting conventions to meet the short-term requirements of boards – so that accounts no longer offer a proper measure of company worth, failing to allow comparison of performance over time or with other firms. Corporate taxation becomes the quixotic result of whatever accounting standards are adopted, allowing boards in effect to choose their level of taxation. Audit needs to be regulated in the public interest, and auditors licensed like banks before they can go into business.

In the search for fees and commissions, investment and merchant banks have become ever more imaginative in their invention of financial assets that can be bought and sold, ranging from the sale of company bank debt to instruments that protect against future share price movements – with the Bank of England indulging the whole exercise as evidence of financial innovation. But this makes the system increasingly unstable, without increasing investment and innovation in the real economy. The system must be forced to exercise greater prudence and the financial institutions' balance sheets must be more strictly monitored. A balance needs to be struck between market contracts that protect against risk, and marketisation that destabilises long-term relationships between finance and industry.

The emergence of giant financial institutions, in particular pension funds, and their growing desire to hold company equity, paying dividends, has been one of the biggest motors of short-termism. Government and company bonds, of course, pay fixed rates of interest. Equity has offered a measure of protection against inflation, with profits and dividends tending to rise at least in line with inflation; but it has also been attractive because dividends have risen significantly in real term. As a result pension funds hold 85 per cent of their assets in company shares, bringing their total holdings of shares of 40 per cent of the value quoted on the London Stock Exchange.

Dividends are meant to fluctuate with profits but pension funds, with their long-term liabilities to their pensioners, cannot afford such fluctuation. For them, dividends need to be as secure as fixed-interest investments with the extra bonus that they always rise – and companies are now yoked to this demand from their principal shareholders with all the adverse consequences. Pension funds and insurance companies have become classic absentee landlords, exerting power without responsibility and making exacting demands upon companies without recognising their reciprocal obligation as owners.

Some funds have begun to exercise responsibilities, questioning some of the more outrageous executive pay deals, but typically the British savings institution is a supine accomplice of the board – happy to go along with corporate strategy as long as the financial returns are high. Their power to affect the course of whole industries is extraordinary. For example, Mercury Asset Management, one of the largest City investment managers, settled the fate of London Weekend Television in its fight for independence from Granada and so set in train the spate of takeovers and mergers in the independent TV sector. Should one person in one investment management group have such power? Should the sole criterion for such decisions be the maximisation of short-term value for the funds which he or she manages? Although the funds will resist the limitations on their freedom that new proposals on takeovers and their participation in corporate governance would imply, in fact they need to be relieved of such awesome responsibilities – or at least be forced to treat them as would properly informed shareholders rather than institutional rentiers.

However, the power of pension funds and institutional saving has not grown in a vacuum; it is the direct consequence, as we have seen, of the explosion of home-ownership and the private provision for old age, with the state progressively abdicating its responsibilities in the name of “choice” and “self-reliance”. Pension fund contributions, the underlying fund and the final payment are all free of tax. The private has been privileged at least in part because of Britain's weaknesses in providing a solid state pension. That would demand a binding contract between the generations, but in Britain such contracts are expressed through Parliament whose guiding principle is that it cannot bind successors – a principle faithfully followed when the Conservatives carelessly debauched the SERPS scheme. Any inter-generational contract cannot be trusted – and the same is true for the provision of social housing.

As a result people have exploited tax privileges and protected themselves with private and occupational pensions, while even those for whom homeownership is unsuitable have been forced to join the stampede into owner occupation, increasingly financed with an endowment insurance policy to pay off the mortgage. The consequence has been a flood of institutional savings, an acute demand for dividends and the foreshortening of investment time-horizons. These savings, if the wider financial system had been reformed to accommodate their new power and demands, could have been and still can be a fruitful source of finance for investment. Instead they have become destabilising.

NOTE

1. Only the Agricultural Mortgage Corporation continues to play a public part, albeit small.