In the slog of a cold winter unexpected good news can lift one’s spirits. That happened to me the last Friday in January when late in the afternoon after markets had closed, the Federal Reserve brought a hammer down on Wells Fargo — Minnesota’s largest bank by deposits. After more than a decade of bank regulators always erring on the side of leniency, the Fed acted with a bit more oomph. That is welcome.
Don’t read too much into this, however. It was a switch from a tack hammer to a medium ball peen, but certainly was not a sledge. Yet it did finally go beyond fines that were miniscule relative to revenue and profits. By capping the size of the bank until further notice, the Fed took a firm grip on Wells Fargo’s “sensitive parts.” This is a bank that could grow significantly in a growing economy, but that is not possible for now, even as its competitors might forge ahead.
Moreover, by requiring the removal of four of its corporate directors, the Fed shined a light on the breakdowns in corporate governance that are at the heart of many of our economy’s problems. It is not clear if the directors were specified individuals who had failed in some way or if it is a version of the French army’s occasional shooting a few inept troops “pour encourager les autres” (to encourage the rest).
None of the deposed directors will end up living in a boxcar or begging spare change at stoplights. Any public humiliation will be brief and little noted. But it is a message to other corporate directors — whose represent the shareholders — that they actually do have a responsibility to pay some attention to what the managers of the bank are actually doing.
OK, that is the psychological boost side of the story. The substance is instructive but somewhat wearying.
Joint-stock business corporations like Wells Fargo are a necessary nuisance. Their invention was a way to marshal large amounts of capital needed for modern-age business ventures — a huge economic advance. This largely started with founding of the Dutch East India Co., or VOC, in 1602. Even 400 years ago, sole proprietorships and partnerships were becoming inadequate for business growth and this remains broadly true. Bill Gates’ or Steve Jobs’ ideas could not have grown to the modern Microsoft or Apple if thousands of other investors had not been brought in. That is the good side.
But it is hard to have corporate governance without there being misincentives at some point that introduce economic inefficiencies.
When Gates’ or Jobs’ companies, or those of Henry Ford, William Boeing, George Westinghouse or Samuel Colt, were still small sole proprietorships, there was no differences between interests of the manager and the owner. The economic model of the manager making decisions to further the long-run-interests of the owner was largely true because manager and owner were the same person.
As firms grew or as they became partnerships, things got more complicated. Not all employees did exactly what was best for their boss and not all partners had identical goals. But businesses had learned to cope with these challenges at least since the time of Rome. When corporations like the VOC came along, they resembled big partnerships. Most stockholders were merchants experienced in trade. The largest of them made up the board of directors and managers were chosen from this group. But as share ownership became more and more diffused, as businesses became larger with more layers of management and as the original merchants or entrepreneurs were replaced by heirs or pure employees, things became blurred.
In theory things are clear. Shareholders own the corporation. Skilled managers, headed by a president or CEO, run the business on a daily basis. Shareholders elect a board of directors to serve as an intermediary to ensure that said managers are, in fact, working only for the best interests of said shareholder-owners.
Reality is much messier. Most shares are not owned by individuals. Instead, mutual and hedge funds and pension managers own the shares on behalf of individual investors. But the incentives of such fund managers are not perfectly aligned with these investors. Their time horizons for growth may be very different and they have very different access to key information.
Board members have little contact with these underlying owners and even less with intermediary fund investors. They have their own reasons for serving on the board and their own time horizons. They have much more contact with the managers that they ostensibly are overseeing than with any layer of the people they supposedly are representing. Many of them may view their appointment to a lucrative position as a favor from some manager. Displeasing that person may end the gravy. And it is hard to know what is going on in the business beyond reports generated by the very managers one is supposed to be monitoring.
Take Wells-Fargo. John Stumpf, the Minnesota-born CEO, was solidly committed to ethical management. He seemed to be doing a great job. Its growth was envied in the financial sector. Stumpf’s subordinates seemed to be on top of things. Analyst’s lauded performance and business magazines touted the bank.
Yet it was rotten underneath. Thousands of employees faced an incentive structure in which they felt they had to commit fraud or be fired. If you complained or tried to blow the whistle, you were axed or ignored. Those who played the game well were promoted.
Stumpf himself seems to be a sincere and honest person. He just was obtuse to what was going on in the company which he was paid many millions to run. There is little evidence that he intentionally mislead the board or fund managers or shareholders or those with money in managed funds. Yet this was a corrupt house of cards.
Some managers at sundry levels of control had to have known what was going on. They had to have lied to some degree or been highly selective in what they reported. Such complicity at one level or another must have gone almost to the top. And it is hard to believe that none of the directors had any misgivings about the source of the spectacular performance. But human nature is such that no one wants to rock a boat, particularly if it is a luxury cruise ship and everyone on board seems content.
What to do?
It is often pointed out that while some 800 people were sent to jail in the wake of the savings-and-loan scandal of the 1980s, virtually no one faced criminal charges for the much larger financial debacle that began to unfold in mid-2007. Is this just because some elite now controls our affairs?
That is a very good question. There are differences. The S&Ls were often quite small, discrete operations, many still under family control, like that of Charles Keating or Minnesota’s own Harold Greenwood. Many individuals did break specific banking laws and their responsibility was clear. So getting convictions was easier than it would have been for anyone at Lehman Brothers or Countrywide Financial or AIG. In larger more complex institutions, especially those that operate across many international jurisdictions, direct responsibility is harder to assign to individuals to a degree necessary to bring to trial. Convicting managers of large corporations is very challenging.
In theory, shareholders should be all the over directors, holding their feet to the fire, challenging them whenever management seems to err, demanding constant vigilance for shareholders rights. Makes you laugh, doesn’t it? Only large institutional investors like Vanguard or CALPERS or activist vulture fund operators get any attention at all from the board-member/executive status quo. And directors who make waves see their terms expire and never get named to another board.
The Fed action against the Wells board is supposed to shake things up a little. If directors know that a regulator like the Fed can step in and sack them, they may feel they need really do what business theory says they should do. Ah, what a pleasant dream!
The Fed did what it could. But the underlying incentive problems are not going to go away. And solving them is a low political priority right now. Don’t expect much to change.