Market governance, financial innovation, and financial instability: lessons from banks’ adoption of shareholder value management

Abstract

As the economy has grown increasingly financialized, the relationship between financial innovation and instability has attracted more attention. Previous research finds that the proliferation of complex financial innovations, like asset securitization and new financial derivatives, helped to erode the market governance arrangements that kept excessive bank risk-taking in check, inviting instability. This article presents an alternative way of understanding how financial innovations and market governance arrangements combine to shape instability. Market governance arrangements also shape how financial firms receive innovations, leading to greater or lesser instability at particular times and places. I illustrate this argument by tracing the effects of changing corporate governance arrangements at large US banks in the 1990s and 2000s. Like non-financial firms in the preceding decade, banks adopted reforms associated with the shareholder value model of corporate governance. These changes to internal bank governance arrangements affected the agendas of bank executives in ways that encouraged expanded use of securitization and derivatives. Drawing from this case, I argue that a full understanding of instability in the financialized era requires closer attention to the (institutionally-structured) interests of financial innovation users-not just to features of financial innovations themselves. Keywords Bank risk-taking. Corporate governance of banks. Financial derivatives. Financialization of banking. Securitization. Shareholder value management Increasing bank reliance on complex financial innovations is a hallmark of the recent turn towards financialization (Bryan and Rafferty 2006; van der Zwan 2014; Cetorelli et al. 2012). Prior to the 1980s, US banks made most of their money from traditional banking activities, like accepting deposits, making loans to consumers and businesses,

The Dynamics of Privately Held Business Assets in the United States

“…Specifically, we highlight three economic transformations that have been shown to contribute to rising inequality in other domains. These include (i) the rapid growth of computing, communication, and automation technologies that are labor-saving and favor non-routine cognitive or communication skills (Autor et al 2003(Autor et al , 2006Bound and Johnson 1992); (ii) the changes in bank strategy that accompanied the turn to financialization (Lin and Neely 2020;Pernell 2020); and (iii) the increase in the market power of large established firms, which has been observed across many industries (Autor et al 2017;Azar et al 2020;De Loecker et al 2020;Grullon et al 2019). In what follows, we discuss each transformation and its potential implications for trends in the distribution of privately held business assets.…”

“…Commercial banks had once obtained the vast majority of their revenue from traditional banking activities, like accepting deposits, issuing loans, and investing in low-risk government securities, but support for this traditional business model started to crumble in the face of rising profitability pressures and changing regulations (Dymski 1999). By the 1990s, a new business model that placed the maximization of shareholder wealth above all other objectives had taken hold in the sector (Dobbin and Jung 2010;Pernell 2020). Increasingly, bank executives sought to boost shareholder value by maximizing short-term earnings and cutting costs.…”

“…Increasingly, bank executives sought to boost shareholder value by maximizing short-term earnings and cutting costs. These strategies attempted to maximize short-term profitability but also put financial market stability at risk (Lin and Neely 2020;Pernell et al 2017;Pernell 2020). At present, we know very little about how this strategic shift has impacted banks' relationships with their traditional customers, privately held business owners included.…”

A Classical-Keynes Model of Money and Finance for Transiting Economies

“…Banks and large financial and non-financial firms are massively and exclusively engaged in acquiring and funding assets in wholesale markets. Furthermore, a 'repo trinity' has been located between fiscal interests concerned to maintain a high demand for sovereign bonds, which demand is sustained through the use of the instrument as collateral in repo market transactions, central bank interests interested in implementing monetary policy through liquid and integrated money markets, and with industry interests in assured funding in a market The explosion in securitisation and the use of derivatives by banks went hand-in-glove with the adoption of the shareholder value maximisation model by firms (Pernell, 2020). Historically, banks relied on the deposits of members of the local community for their funding.…”

Economic development versus the growing importance of the financial sector: Global insight

“…They have led to a kind of risk dilution on the one hand, and on the other hand, they have eliminated the mechanism of limiting excessive risk-taking by banks. That has led to instability and a kind of polarization of innovative financial solutions (Judge, 2012;Głodowska, 2012;Pernell, 2020).…”