The debate on UK corporate governance has focused on the wrong issues, Colin Mayer told an Edinburgh lunchtime meeting hosted by Scotland's premier learned society, the Royal Society of Edinburgh on 21 March. Financial institutions have, for example, been accused of 'short-termism', of placing too much emphasis on short-term earnings fluctuations at the expense of the long-term strategy of the firms they own. They have also, it is argued, failed to control excessive levels of executive remuneration in the companies in which they have invested. Drawing attention to research from the CEPR programme on 'The International Financing of Industry' (funded by ESRC?), Mayer provided a simple explanation for such behaviour. Mayer is Professor of Economics at the School of Management Studies, University of Oxford, former Co-Director of CEPR's Financial Economics research programme and Scientist-in-Charge of CEPR's Financial Economics Network (HCM? funded by?).
Mayer noted that as the main investors in the UK equity market, financial institutions are perceived to have played an inadequate role in monitoring and controlling companies. Too much reliance is thought to be placed on takeovers, often regarded as an expensive method of trying to improve corporate performance, highly disruptive to management, and forcing companies to concentrate unduly on short-term performance. Several improvements to corporate governance have been proposed, notably by the Cadbury Committee. Its attention focused on separation of the roles of chairman and CEO, the appointment of more non-executive directors to boards, and the establishment of remuneration committees. Institutions have been exhorted to take a more active role in overseeing management, and to take direct action in cases of poor management.
But the apparently limited involvement of institutions can largely be explained by the dispersed nature of UK share ownership. Financial institutions' holdings tend to be diversified across a large number of companies, and they do not typically include a large proportion of the shares of any one company. Shareholdings in excess of 6 per cent are rarely observed in the largest corporations. By contrast, in France and Germany, there are much larger concentrations of ownership: in 85 per cent of the largest 170 German companies and 79 per cent of the largest French ones, there is at least one shareholder with a stake in excess of 25 per cent of the total. In over half the companies, there is a single majority shareholder. In comparison, only 16 per cent of the top 170 quoted UK companies have a shareholder with more than a 25 per cent stake, and in just 6 per cent of cases is there a majority shareholder. Hence, ownership is much more diversified.
This has two consequences. First, there is more of a 'free rider' problem in UK corporate control than in France and Germany. If each shareholder owns only a small part of the firm, no shareholder has sufficient incentive to monitor closely the actions of the firm. Second, and less obviously, there is a lower level of commitment to other stakeholders in the firm. In France and Germany, large shareholders establish long-term relationships with the firm's employees and suppliers. Since they risk losing their reputations by, for example, dismissing employees or breaking relations with suppliers for no good reason, implicit contracts are critical. Dispersed ownership discourages the establishment of long-term relationships since it is impossible to have pacts with dispersed groups of anonymous owners. The widely discussed problem of short-termism may therefore have nothing to with share trading or short-term attitudes on the part of investors. Instead, it may be an inherent characteristic of this particular form of share ownership.
Why then has this pattern of corporate ownership emerged? There are three possible explanations. The first is that it is involuntary: regulation and taxation may have discouraged the retention of large share stakes. For example, UK regulation discourages the use of dual class shares, a central aspect of retention of control by original owners in continental Europe. And inheritance taxes may have caused the offspring of entrepreneurs to sell their companies on the stock market. The second possibility is that the UK system is not as bad as it seems. The significance of the 'free rider' problem may have been overstated: there is evidence that even in large companies, the six largest institutions frequently hold stakes of around 20 per cent between them. Furthermore, poor performance encourages the accumulation of large share stakes: share trading results in higher concentration of ownership in poorly performing companies. Thus, where it is needed, the market may be better at providing good corporate governance than is often thought. The third possibility is that there may be advantages associated with dispersed ownership. The converse of long-term relationships is flexibility. If firms are not tied to particular employees or suppliers, then they can look around for the cheapest sources of labour and other inputs. In other words, the UK (and US) systems are associated with the development of more active short-term markets, greater mobility of labour, and competitive product markets for suppliers and purchasers.
This accords well with the stylized distinction between the UK and US versus continental Europe and Japan. The UK system of corporate ownership and governance is intimately tied to a form of capitalism which emphasizes competitive short markets at the expense of long-term relationships. There will be some industries and markets which benefit from lower input costs derived from competitive spot markets, and others which are disadvantaged by the absence of long-term relationships. Mayer concluded that in focusing on corporate governance, the debate of the last few years has therefore addressed the wrong issues. Instead, it should be examining whether the UK's particular structure of capitalism with its emphasis on competitive spot markets, short-term relationships and dispersed share ownership is well suited to the needs of the economy in the twenty-first century? How rapidly can the UK's system respond to changing circumstances? And are there any impediments arising from taxation and regulation, for example, which might prevent the natural emergence of the most appropriate form of capitalism?