Strong Managers, Weak Owners: The Political Roots of American Corporate Finance

Abstract

In a broad-based democracy, not all contracts will survive. Even some efficient contracts will be banned, if enough people dislike them. Thus if the average voter dislikes powerful private financial institutions, politics will, all else being equal, ban them. Interest groups cancel one another out. One group wants powerful financial institutions and another, such as small-town bankers, does not. The small-town bankers have a leg up in the political infighting, because popular opinion is on their side, leading to a ban on some arrangements that a less regulated economy might produce. Or, to recast the problem in agency cost terms, managers would like to be free from the oversight that powerful financial intermediaries might provide, and in the modern era, politicians might side with managers when the managers’ goals of thwarting takeovers align with a public wary of too many hostile takeovers. The politician can satisfy the managerial interest group and be popular at the same time. Agency costs move into the political arena; some contracts are banned, and whether the substitutes that arise are always perfect ones, without additional costs, is an open question.

Law restricted the dominant financial institutions from the end of the nineteenth century onward. American banks were fragmented geographically, lacking the size to take big slices of capital of the large American firms emerging at the end of the nineteenth century. Banks’ products and portfolios have been further restricted: they were barred from the securities business and from owning stock. Their affiliates were also restricted in the stock they could own. Insurers could not buy stock for most of this century. Mutual funds cannot easily devote their portfolios to big blocks and face legal problems if they go into the boardroom. Pensions cannot take very big blocks without legal and structural problems; the big private pensions are under managerial control, not the other way around.

These rule were neither random nor economically inevitable. While public interest goals of keeping financial intermediaries prudent and stable explain some of the rules, they do not explain all of them. Two dominant themes lay behind many of the rules: American public opinion, which mistrusted private large accumulations of power, and interest group politics. There were winners in fragmenting financial institutions. These winners had a large voice in Congress, and their goals matched public opinion. For example, small banks wanted to shackle large ones and succeeded in getting and keeping branching limits, banks on banks in the securities business, banks on bank affiliates’ moving outside of banking, and deposit insurance (which, by guaranteeing depositors that they will be paid if the bank fails, helps smaller, weaker banks more than it helps more solid, often bigger banks).

These features of the political economy of American finance became foundational for corporate finance and the separation of ownership from control.

Keywords: corporate governance, blockholders, institutional investors, Glass-Steagall, populism, unit banking, corporate takeovers, short-termism, agency costs

JEL Classification: K4, H73, G34, G28