“Strategic Failure” in the Financial Sector: A Policy View

Abstract

Analysis of the recent financial crisis has tended to focus upon “market” and corresponding “regulatory” failures. While this provides important insights, it may neglect deeper issues at the root of recent problems. In this paper, we take a broader perspective, drawing upon the stategic choice approach to the theory of the firm (Cowling and Sugden, 1998, 1999). We present a governance-based analysis which emphasises the process of engaging interested “publics” in corporate decision-making processes. We illustrate our arguments with respect to three UK cases – Northern Rock, Bradford and Bingley, and HBOS banks – which each required major interventions by the UK Government and whose recent history reveals significant changes in ownership, governance and corporate strategy. We argue that the current period of reform for these former building societies represents an ideal opportunity to address serious concerns over governance within the financial sector, and we propose a revised mutual solution as one appropriate way forward.

Key Words:

• Regulation
• Governance
• Strategic Decision Making
• Strategic Failure
• Ownership
• Mutuality
• Financial Sector

JEL classifications:

• G21
• G38
• L21
• L52

Notes

1. A “building society” is a mutually owned bank which specialises in mortgages and saving products. These institutions are very similar to the “savings and loan associations” of the United States.

2. The Commission on Ownership was set up in the UK following the financial crisis in order to establish “a new and clear understanding of the influence that ownership has on the governance of our country, on British businesses and in the public sector”. See http://ownershipcomm.org/ for more information.

3. Long draws in particular on the seminal work of Dewey (1927) in analysing the public interest: for a more detailed analysis, see Sacchetti and Sugden (2007).

4. The baby analogy is useful for a further point regarding regulation. Sometimes the public is “wrong” and regulation is needed to limit what they would otherwise like to happen. It isn’t always appropriate for a child to stay up late and eat chocolate. The key difference in this situation is that utilising regulation alone removes (or at the very least reduces) the possibility of the public themselves from identifying superior solutions or outcomes. The public in this setting has no possibility of using Hirschman’s (1970) concept of voice.

5. The Walker Review was commissioned in February 2009 by the then UK Prime Minister, Gordon Brown, and was chaired by David Walker of the Audit Commission. The review made 38 recommendations in relation to reforming corporate governance within the UK banking and finance sector. Further details are available at http://www.hm-treasury.gove.uk/walker_review_information.htm

6. The FSA’s creation in 1997 was part of a new financial framework where the (independent) operation of monetary policy was assigned to the Bank of England, which in turn relinquished responsibilities for financial supervision to a new body (the FSA) to avoid any “conflict of interest” (see Di Noia and Di Giorgio, 1999).

7. It is also noteworthy that, in addition to these three cases, not one of the other demutualised building societies has survived as an independent financial institution, the others being subsequently taken over by rival banking groups (Michie and Llewellyn, 2010).

8. See Shin (2009) for a more in-depth overview and analysis of the collapse of Northern Rock.

9. To comply with EU state aid rules, the enlarged Lloyds Banking Group was required to divest a significant package of branches, brands and customer accounts. It was announced in December 2011 that the mutually owned Co-operative Banking Group was the preferred buyer of these assets, which seems prescient given the arguments for mutuality contained later herein. See BBC News (2011d) for more details on the sale.

10. In the latter case, it is suggested that this option is unlikely to work given the large scale of the utility business. However, another option being considered is a “Public Benefit Corporation”, which would own the organisation “for the people” in a similar way to the “company limited by guarantee membership” model that we mention in Section 5.3.

11. The demutualisation process was exacerbated by the entrance of “carpet baggers”, who became members in anticipation of participating in the expected “windfalls”. In essence, demutualisation engineered an intergenerational redistribution of reserves, as current members appropriated value built up by previous generations of members (Llewellyn, 2009b).

12. Building societies were not immune to the crisis. However, their problems largely emerged due to the subsequent downturn in the property market (which resulted from the crisis) rather than any over-reliance upon wholesale funding (Llewellyn, 2009b).

13. See overview in Scottish Futures Trust (2010).

14. In order to ensure stability and safeguard against further demutualisation (which current legislation would allow), some form of “asset lock” preventing members from realising the mutual’s underlying assets might be put in place. This could be achieved by legislation, but in the short term, charitable assignment practices that have been a successful defence (against demutualisation) in existing building societies may suffice (Michie and Llewellyn, 2010).

15. Whilst our analysis has been applied to building societies, it should be noted that much of the content could also be applied to credit unions. Credit unions are relatively small, mutually owned financial service institutions where membership is restricted to those with a “common bond” (such as common geographic location or place of work). They account for a very small share of the UK financial market, but are seen to have a big role in combating social exclusion. For more on the functioning of credit unions in general, see Chambers and Ryder (2008), McKillop et al. (2007), Ryder and Baker (2003) and Ward and McKillop (2005). For evidence of similar problems with their governance that we have highlighted for building societies herein, see Bauer et al. (2009), Davis (2001) and Leggett and Strand (2002).