Matthew Hancock MP: The right are right to challenge rewards for failure

In a speech to Policy Exchange today Matthew Hancock MP, co-author of the recent book Masters of Nothing, has outlined the ways in which ‘rewards for failure’ are both wrong ethically and bad economically. He has described how tackling such rewards is completely consistent with conservative and free-market beliefs and how he believes the Conservative Party is ideally placed to challenge the culture of ‘rewards for failure’ and the issue of executive pay more widely.

In his speech, he said:

“It’s been called the ‘something for nothing’ culture, economists call it rent extraction, I call it rewards for failure.

“These examples of rewards for failure are part of a broader something for nothing culture that grew up in our welfare system, in parts of the public sector, and in some of our boardrooms too.

“I want to argue that on both counts – on the economics and on the ethics – rewards for failure must be addressed and that addressing them runs deep in the conservative tradition.

“For years Labour failed to act, afraid as they were of upsetting the Faustian pact they had entered into: to let banks rip and spend the tax revenues. We all know how that ended.

“The rule of law; enforcement of contract; monopoly controls; anti subsidy; insider trading rules; these are all crucial to well functioning markets, to ensure markets are fair, so success to link reward to success not failure.

I want to see a law which makes it possible to prosecute executives for serious financial recklessness. Our goal must be to make executives think harder about the consequences of their actions, and change the culture of finance so it is safer for us all.”

 

You can read a copy of full speech below:

“It’s been called the ‘something for nothing’ culture, economists call it rent extraction, I call it rewards for failure.

It turns society against the source of its own prosperity.

It harms the economy.

It’s unethical.

And it needs a solution.

Between 2000 and 2007 the value of FTSE 100 companies measured by market cap grew by 10%, yet over the same period bonuses to executives trebled.

Last year FTSE 100 directors’ total earnings rose by 49%, while share prices barely rose.

Adam Applegarth took Northern Rock from a successful building society to the first British bank run in 150 years. He left with a £760,000 pay-off and a cut-price staff mortgage.

Sir Fred Goodwin’s £350,000 a year pension gave a new meaning to the phrase ‘got off Scot free’.

It’s not just in high finance.

Fabio Capello is still the England manager despite our woeful performance in the football world cup, after a release clause was removed from his contract.

These examples of rewards for failure are part of a broader something for nothing culture that grew up in our welfare system, in parts of the public sector, and in some of our boardrooms too.

Now I am all in favour of people who work hard and are successful being richly rewarded.

But rewards for failure are bad ethics and bad economics.

I want to argue that on both counts – on the economics and on the ethics – rewards for failure must be addressed and that addressing them runs deep in the conservative tradition.

From Peel’s decision to repeal the Corn Laws, to Thatcher’s battle to end taxpayer support for an unproductive, unprofitable industry.

Indeed David Cameron has led on this agenda of corporate responsibility for years. It is of course welcome more recently to see Ed Miliband also engage.

But for years Labour failed to act, afraid as they were of upsetting the Faustian pact they had entered into: to let banks rip and spend the tax revenues. We all know how that ended.

Now some people say the Right should not talk about this subject.

But on the contrary, it is those of us who understand the power of free markets who should be most offended when they fail.

After all, the link between effort and reward forms the very basis of the market’s moral authority. So this is an issue of far more concern to supporters than any opponent of capitalism.

Conservatives should be no more uncomfortable tackling rewards for failures at the top as at the bottom of society.

I come here not to bury markets but make them work better.

And it is we who understand free markets who are best placed to make those reforms.

Ethical argument

I said there is an economic and an ethical case for action.

Let me first make the ethical case.

One of the oldest political debates is over the meaning of fairness.

The former Government seemed to define fairness by those bar charts the IFS produce.

A static sort of fairness as equality. If you moved some people from just below an arbitrary point of measurement, to just above, they said, your policy was deemed fair.

But in the pursuit of this static fairness, the consequence was to undermine fairness in terms of just rewards.

For most people, fairness is not found in a bar chart. Of course there must be a safety net, but fairness is also dynamic, on the principle that you get out according to what you put in.

This very British understanding of fairness is the ethical basis of the free market: that those who work hard, and produce things others will pay for, they prosper. Those who succeed in making others’ lives – customers’ lives – better, are rewarded. A system that supports these principles rewards aspiration, work, opportunity and effort.

A well functioning market is not amoral: it is deeply ethical on the basis of that reciprocity. Conservatives understand that.

But just as those who oppose markets are not well placed to reform them, some don’t think we have any moral authority to intervene at all.

One critic of intervention recently suggested that anyone unhappy with the state of British capitalism should ‘move to Cuba’.

But as Jesse Norman has eloquently argued, the very institutions of the free market – corporations, banks, limited liability – are themselves invented by law, so the question is not if the state should intervene, but how.

Forty years ago Milton Friedman - that great godfather of deregulated capitalism - wrote a famous article entitled ‘The Social Responsibility of Business is to Increase its Profits’.

The article became a lodestar for those who wanted to believe that when they went into work they could leave their conscience at the door: not only that there is not, but that there ought not be any moral dimension to corporate behaviour.

But the amoralists saw the headline and didn’t read the argument.

Friedman made a vital caveat. He understood the crucial role of the frameworks culture in which markets operate.

Here’s what Friedman actually wrote:

He said it is the social responsibility of business to “make as much money as possible, while con­forming to the basic rules of society, both those embodied in law and those embodied in ethical custom.”

“Ethical custom.”

So there you have it. The Lord High Master of free market economics making the case for ethical customs in markets.

Like his disciple Margaret Thatcher, I believe Milton Friedman would be shocked by the golden parachutes and the rewards for failure we see today.

He would see them as a violation of property rights.

The rule of law; enforcement of contract; monopoly controls; anti subsidy; insider trading rules; these are all crucial to well functioning markets, to ensure markets are fair, so success to link reward to success not failure.

Economic argument

This brings me on to the economic case against rewards for failure.

We’ve all heard the answer given by top earners when challenged on excessive pay: “in a competitive global market you have to pay competitively to get the best talent”.

But the question no-one can answer for me is this how come the same people argue that at all other levels competition exerts a downward not upward pressure on pay.

Why?

Could it be that the performance of top managers is rising sharply? The evidence is not strong.

It could be that the demand for senior bankers is outstripping supply. That’s a hard case to put given the state of the industry.

It’s not even the global going rate. Chinese and Indian executives run similar sized firms often for a fraction of the price. The CEO of the world’s biggest bank by market cap - the Chinese ICBC - earns only $235,000 a year.

I think it comes down to misaligned incentives, mostly in the form of a principal/agent problem. These misaligned incentives underpin the market failure and so the economic case for reform.

In plain English, the interests of owners are misaligned from the interests of the manager.

The chain from ownership to control is broken.

Let us examine the chain to work out what to do about it.

The owner, mostly retail savers, often entrust their capital to the fund manager.

The fund manager then owns the shares and technically appoints the board.

The board hold the executive to account.

And the executive runs the company.

I grew up in a small family business, where reward was tied directly to effort. The idea of a big payoff when things go wrong or a bonus when the company isn't doing well is anathema to real business people the world over. Even more so, in employee partnerships owners are employees too.

But in PLCs, this long chain of intermediaries characterises the majority of big companies.

At each link in the chain incentives can be misaligned and action must be taken to repair each link.

Research by the New York Fed makes clear that the wrong incentives not only harm the performance of companies, but also harm the economy. A strong economy rewards success, not failure.

Proposals

So let me briefly take each link in turn.

First, the pay of fund managers can be reformed, for example, to reduce flat rate fees that pay out for simply following the herd, and instead more closely rewards performance for the saver.

Second, the shareholder power can be strengthened, for example by binding votes on pay, and by a public protagonist to challenge the views of management presented at an AGM. Welcome progress has been made in the past year or so on disclosure of voting, and in particular voting on appointment of directors. But more shareholders need to step up to the plate.

Third, non-executive directors should be strengthened, as they are the shareholders’ representatives. Better than complex rules would be to strengthen their accountability.  The best type of NED would be prepared to resign rather than sign off a proposal against the interests of the company. But how often does this happen? So we should strengthen the sanctions they face if they fail to stand up for shareholders, and in the worst case NEDs should be debarred from other directorships.

Strengthening the sanctions for Directors would focus minds, and mean NEDs spend more time in the firm, understanding its business, asking the tough questions, and holding executive management to account.

Remuneration Committees too are part of the board structure, and their role in keeping pay linked to performance must be strengthened, as the Prime Minister has signalled.

And finally, direct incentives can be brought to bear on executives themselves.

In banking, I think that the history of demutualisation led to many of the existing problems. When investment banks were partnerships the partners put everything at stake, were amply rewarded, but were extremely careful with their money. But when they demutualised the returns continued to go to the same people, even though they were no longer necessarily the shareholders.

So I welcome the introduction of clawback requirements in bank pay structures. I warmly welcome the new Financial Policy Committee’s instruction that banks should use cash to strengthen their balance sheets not pay out bonuses or dividends.

The big banks have a special responsibility. They are part of the plumbing of the financial system and they bear the responsibility of enjoying an implicit subsidy.

When most companies go bust, their shareholders and employees take a hit. When a systemically important bank goes bust, the whole economy is affected, and taxpayers too often have to pick up the pieces.

Those who put our big banks at risk in this way should be held to account, just as with those who destroy property, or endanger the health of their fellow citizens.

Sir Fred Goodwin broke one of Britain’s biggest banks, yet walked away with a huge pension. I want to see a law which makes it possible to prosecute executives for serious financial recklessness.

One way would be to create an offence of gross negligence in valuation, where executives had failed effectively to value an asset or acquisition.

Senior executives would have a duty to performe due diligence, and an obligation to disclose any information shareholders might reasonably expect to see. 

In the case of the RBS board’s disastrous acquisition of ABN AMRO it is clear that due diligence was inadequate and they failed to take account of severely deteriorating market conditions at the time of the acquisition. Such serious omissions would become illegal under the new law.

I would hope such legislation would never have to be used. But the shadow of prosecution will concentrate minds of those entrusted with institutions of vital national importance.

Our goal must be to make executives think harder about the consequences of their actions, and change the culture of finance so it is safer for us all.

So tackling rewards for failure is morally right and economically sound.

But there’s one other reason too.

For the free market is the most powerful force for progress ever invented.

We who understand that must ensure that the free market works for everyone, that all share in its success, and for a new generation make the argument

For freedom,

For prosperity, and

For an economy that works for all.”