Shareholder value maximization (SVM) & the financial crisis

How Business Schools Lost Their Way

If business school were a church, shareholder value maximization would be its religion. Two INSEAD professors say it's time to find a new one

By N. Craig Smith and Luk Van Wassenhove

January 11, 2010 | BusinessWeek

Business schools have been blamed for the economic crisis. Their MBA students are said to be responsible for wreaking the havoc in the financial markets we are all now suffering from and business schools are chastised for not training them better, not least in failing to instill a clear sense of right and wrong.

Are they to blame? To the extent that MBA graduates have been closely associated with many of the spectacular failures of financial institutions witnessed over the last 18 months, they may justifiably be criticized for the mispricing of risk in relation to specific financial products and an underestimation of systemic risk more generally. They may also be criticized for failing adequately to question the assumptions of the financial models being used and, with hindsight at least, for following the crowd and gambling that they could continue to dance, to borrow the unfortunate phrase of Citibank's (C) Chuck Prince (not an MBA), when it was way past time to be off the dance floor.

In some cases, where perverse incentives of compensation systems were at work, the criticism also seems warranted that these individuals focused solely on serving their own self-interest and gave scant regard to their obligations to others, even shareholders. Much like a dodgy second-hand car salesman, it seems, they knowingly sold flawed products—such as the mortgage-backed securities they knew would blow up because of unsound origination processes. Worryingly, these practices were evident in the financial institutions that have survived—and some that have prospered—in the crisis, as well as those that failed.

INDIRECT ROLE

It would be a mistake to say that business schools are directly to blame, even when their graduates were closely involved; there are more basic drivers. But business schools have played a role indirectly, due fundamentally to their adherence to and perpetuation of an ideology that has contributed significantly to the crisis, albeit unintentionally. That is the ideology of Shareholder Value Maximization (SVM). In most business schools, SVM is the leitmotif of finance teaching and implicit throughout the rest of the curriculum.

Ideologies often appear to be serving society as a whole while advancing the interests of particular sectors. So it is with SVM. The economic theory of the corporation holds that SVM results in the best social outcome: societal wealth maximization. But at the same time it serves the interests of shareholders and the managers who are its adherents and its beneficiaries, at least when their compensation is pegged to shareholder returns. This criticism of SVM is not to suggest shareholders are unimportant; they warrant a return on the capital they provide that reflects the financial risk incurred. However, this is not the same as maximizing shareholder value.

A theory advanced in business schools to justify SVM says shareholders are the "residual claimants." Shareholders, the theory goes, should be uppermost in the minds of management, because they receive their returns only after the claims of other stakeholders have been met. This is evident in companies meeting their contractual and legal obligations to stakeholders such as employees, but it is also evident in companies meeting noncontractual obligations determined by economic factors. For example, these might be obligations beyond legal or statutory requirements to a local community affected by a plant closure, where the company identifies that its reputation might be harmed and it might suffer an economic loss if the obligations are left unattended. As this example might suggest, however, not all ethical obligations would be reflected in a potential economic loss, even in the long term. Consider a management practice of engaging in bribery when one can get away with it. This might be consistent with shareholder value maximization, but not advancing societal welfare.

FAULTY ASSUMPTIONS

The theory also relies on assumptions amply demonstrated as lacking in recent months. For example, it assumes effective government regulation to ensure everybody plays by the rules and to manage externalities (outcomes not readily susceptible to market sanctions, such as pollution). It also presumes effective corporate governance such that shareholders hold management to account. More technically, it relies on various economic assumptions, such as the efficient market hypothesis (that share prices reflect all relevant information on the stock).

Aside from the assumptions required in subscribing to the SVM model and the potential ethical issues left unaddressed, there are major practical considerations in the teaching and application of the SVM ideology. While professors might explain in detail how the underlying theory of SVM treats shareholders as residual claimants, what matters is the message students take away. That message is shareholder primacy—that their purpose in business is to make decisions that put the interests of shareholders above all others.

When they go into their jobs—in finance and elsewhere—they find an environment that marches to the same tune and is incentivized to do so. The theory of SVM generally translates into practice through the mechanism of the share price. This flawed and often easily manipulated measure of long-term company value is then used as a basis for business decision-making. This has huge potential consequences for the individuals involved (rich bonuses they may not deserve) and their organizations (short-term decisions that harm long-term viability), as well as society.

DIFFERENCES IN THE DEVELOPING WORLD

If SVM is problematic from a developed world perspective, it can be disastrous from the perspective of the developing economies where global business and MBAs increasingly are to be found—as well as most of the 1 billion people going hungry in the world. Many large companies today operate in countries with little or no government and a huge potential for corruption, and, given such technologies as the Internet and mobile phones, how they operate can be instantly broadcast worldwide. Today's global business environment is not the simple U.S.-centric world of free-market economist Milton Friedman. It is far more complicated.

What should business schools do? While late in the day, perhaps, Jack Welch was right when he described SVM as "a dumb idea." Business schools need to stop worshipping at the altar of SVM and teach it with greater intellectual honesty and with attention to its many deficiencies, both theoretical and practical. They also need to do a better job of developing its most plausible contending framework: stakeholder theory. This is a more complex but current and realistic view of management, one that recognizes that the task of managers is to serve multiple stakeholders—giving shareholders their due, but not to the exclusion of others with legitimate claims.

Finally, business schools should give more attention to their input as well as output. With starting salaries for MBA graduates often well in excess of $100,000, business schools need to be careful not to attract narrow-minded, self-centered people who might see a way to get rich quickly by eagerly and unquestioningly embracing an ideology that serves that end. Business schools should look to attract and properly train people to be responsible leaders who are well-rounded and have the capable minds and the courage to ask the critical questions that went unasked for too long.

N. Craig Smith is a professor of ethics and social responsibility at INSEAD. Luk Van Wassenhove is a professor of operations management and academic director of the Social Innovation Centre at INSEAD.