March 29, 2011
Dallas on the Great Recession
Lynne Dallas has posted Short-Termism, the Financial Crisis and Corporate Governance on SSRN with the following abstract:
This paper is a comprehensive exploration of why financial and non-financial firms engage in short-termism with particular attention given to the financial crisis of 2007-2009. Short-termism, which is also referred to as earnings management or managerial myopia, consists of the excessive focus of corporate managers, asset (portfolio) managers, investors and analysts on short-term results, whether quarterly earnings or short-term portfolio returns, and a repudiation of concern for long-term value creation and the fundamental value of firms. This paper examines how market and internal firm dynamics contribute to short-termism by considering various structural, informational, behavioral and incentive problems operating within firms and markets.
Regarding structural problems, this paper explores how the internal dynamics of traditional and shadow banks contribute to short-termism. It also explores the contribution of short-term (high turnover) trading, including momentum and high frequency trading, to short-termism. It examines the role of "dumb money" (noise traders) in causing overvalued equity resulting in over-investments by non-financial firms, and the role of transient institutional investors in contributing to earnings management by managers of non-financial firms. It also addresses the ability of activist shareholders through the use of shareholder voting rights or takeovers to use non-financial firms as short-term arbitrage opportunities.
This paper also examines competitive pressures on firms, such as where markets present manager with a prisoners’ dilemma in which the dominant strategy is to engage in earnings management. In addition, the paper considers how informational problems in markets lead firms to utilize myopic signal and signal jamming behaviors and how these inefficiencies create a market for lemons in which such behaviors are encouraged. It also considers behavioral factors that contribute to short-termism, such as overoptimism, herding, and the tendency to underestimate or disregard low-frequency economic shocks. This paper also explores cultural aspects of financial and non-financial firms that foster short-termism, particularly in trading firms, and the importance of executive compensation arrangements to firm cultures.
Finally, this paper considers various regulatory responses to mitigate short-termism, including an evaluation of relevant provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. The paper proposes coordinated and functionally equivalent regulation of the traditional and shadow banking system. It also proposes regulation of financial products, such as derivatives, collateralized debt obligations and subprime mortgages, and disclosure and due diligence obligations for those involved with such products, such as issuers, underwriters and credit rating agencies. It proposes a reexamination of financial reporting obligations to focus market participants on long-term value and true drivers of business success. In addition, it proposes that states change their corporation law to provide that only long-term shareholders may vote. Long-term shareholders would be defined by the duration of their share ownership and the characteristics of their portfolios. In addition, a reexamination of fees or taxes on securities transactions, including stock, debt and derivative transactions, is proposed as well as consideration of modifying capital gains taxes. Finally, changes in fiduciary duty law, board structure, and executive compensation arrangements are proposed to mitigate short-termism. It is the objective of this paper to seek changes that would prevent a financial crisis in the future, such as the financial crisis of 2007-2009 that has had such a devastating impact on the United States and global economies.
March 29, 2011 | Permalink