A Brief Review of the Role of Shareholder Wealth ion and Other Factors Contributing to the Global...

8/3/2019 A Brief Review of the Role of Shareholder Wealth ion and Other Factors Contributing to the Global Financial Crisis

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A brief review of the role ofshareholder wealth maximisationand other factors contributing to

the global financial crisisNoel Yahanpath and Tintu Joseph

Eastern Institute of Technology, Napier, New Zealand

Abstract

Purpose – In the aftermath of the global financial crisis (GFC) governments lost confidence in marketfundamentalism and realised the inadequacies of regulatory measures. The purpose of this paper is tooutline the proximate causes of the financial crisis of 2007-2009 and to investigate the role of the

shareholder wealth maximization (SWM) objective in the GFC.Design/methodology/approach – The methodological procedure used in this paper is based on thehistorical case-study approach. Case reviews of individuals and world-level role models of the financialcrisis have been cited in this paper. From this aggregated material, the paper examines the side effectsof the SWM objective in order to develop the argument that the SWM objective played a role in thepresent crisis.

Findings – The case studies revealed that unethical behaviour, agency issues, CEO compensation,creative accounting and risk shifting are some of the side effects of SWM. These cases indicate that theassumptions on which SWM are based are questionable. Further, it can be argued that the root causeof the GFC is excessive greed and the single-minded pursuit of SWM.

Originality/value – Though many studies have attempted to identify the proximate causes of theGFC, this paper is novel in highlighting the impact of the SWM objective function.

Keywords Shareholder analysis, Wealth, Globalization, Recession, Strategic objectives

Paper type Literature review

1. IntroductionThe global financial crisis (GFC), which had been threatening for some time, began todisplay its effects in the middle of 2007 and into 2008. Around the world, stock marketshave fallen, large financial institutions have collapsed or been bought out, andgovernments in even the wealthiest nations have had to develop with rescue packages tobail out their financial systems. It is argued here that the problems could have beenavoided if ideologues supporting the current economics models were not so vocal,influential and inconsiderate of others’ viewpoints and concerns. What is more, it wasnever suspected, at micro level, that the corporate objective of shareholder wealthmaximisation (SWM) had a major role in the crisis.

The financial sector, in spite of arguably being underestimated by some experts,remains one of the pillars of the contemporary process of production and consumption;this is why all developed economies have developed a strong financial industry.The current financial crisis brings to light financial hypertrophy theory which arguesthat the origin of the current economic problems is that contemporary economies haveexcessively developed the financial field, neglecting the primary production process(Rafaschieri and Rafaschieri, 2009).

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Qualitative Research in FinancialMarketsVol. 3 No. 1, 2011pp. 64-77q Emerald Group Publishing Limited1755-4179DOI 10.1108/17554171111124621



The deregulation of the capital and securities market in Europe and the USA in thelate 1980s, which changed the nature of the production process, as well as theinternationalisation of financial transactions, is welcome results of economicglobalisation. Many analysts consider the emergence of a trans-national financial

system as the most fundamental and defining feature of our time. Increased mobilityamong different segments of the financial industry – with fewer restrictions and aglobal view of investment opportunities – were the attractions of the liberalisation of financial trading. Advancements in the field of data processing and informationtechnology gave added momentum to the growth in tradeable financial value. Aided bynew communication technologies, global entities and speculators earned spectacularincomes by taking advantage of weak financial and banking regulations in theeconomies of developing countries.

The Central Bank of the USA, led by Federal Reserve Chairman Alan Greenspan,kept interest rates very low for a long time to blunt the recession of the early 2000s.The resulting under-investment and over-consumption by investors and consumers,

respectively, prompted the development of a housing bubble that ultimately burst,precipitating the financial crisis. This crisis, together with sudden and necessaryde-leveraging and cutbacks by consumers, businesses and banks, led to the recession.Austrian Economists argue further that, while they probably affected the nature andseverity of the crisis, factors such as a lack of regulation, the Community ReinvestmentAct and activities of entities such as Fannie Mae and Freddie Mac are insufficient inthemselves to explain the severity of the crash (Lawrence and David, 2009).

In addition to macro-level issues, we discuss micro-economic factors in Section 3.Even though there is a well-developed body of knowledge in both areas, to ourknowledge no attempt has been made to examine the role of the SWM corporateobjective function in the crisis; in this paper, we have therefore revisited the issue, citingmore recent case studies to argue that there are some fatal flaws in the assumptions on

which the pursuit of SWM is based.The remainder of this paper is organised as follows. The methodology is presented

in Section 2. In Section 3, we briefly discuss five factors that contributed to the presentcrisis, in order to develop the argument that the SWM corporate objective function hada role in the GFC. Section 4 presents case studies to illustrate the side effects of SWM.Section 5 provides a discussion of the case studies, before Section 6 summarises andconcludes. The main conclusion drawn from the study is that almost all of the rootcause of the financial crisis was the pursuit of SWM.

2. MethodologyThe methodological procedure used in this paper constitutes historical case studies

and appropriate literature to examine the role of the corporate SWM objectivefunction in the financial crisis. Yin (2004) suggested using multiple sources of evidence as the way to ensure construct validity, while Levy (1988) shows thatmultiple case studies follow replication logic. Similarly, Stake (1995) argues thatinformation generated by case studies would often resonate experientially with abroad cross-section of readers, thereby facilitating a greater understanding of thephenomenon. From this aggregated material the argument that SWM pursuitcontributed to the crisis is developed.

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3. Factors that contributed to the GFCThe world economy has overcome various phases of recession and financial bubblebefore. However, the burst of the bubble this time had a severe impact because it wasmore than a simple financial bubble, but involved a credit-fuelled real asset bubble as

well. The liberal financial policy has also contributed much to the crisis; in an interviewwith Finsia, Stephen Roach, Chairman of Morgan Stanley Asia, expressed the viewthat had the banks maintained a tighter financial policy, a GFC would not have beenpossible, although growth would have been hampered. Politicians also focus oneconomic growth irrespective of the consequences; while trying to stimulate growth,government and other policy makers have to consider the cause-and-effect relationship(Stiglitz, 2010). Although too late, one aftermath of the crisis was that governments lostconfidence in market fundamentalism and realised the inadequacies of regulatorymeasures. In addition to the above broader issues, we argue that five specific factorsthat contributed to the crisis and these are now set out.

3.1 Over-leveraging, credit default swaps and collateralized debt obligation

When a company is financially geared,the variation in thelevelof earnings dueto changesin trading conditions generates more than proportionate variation in earnings attributableto shareholders. Hence, such companies are regarded as relatively risky (Pike and Neale,2006). Whilst acknowledgement of financial risk is long-standing in mainstreamfinance literature, it is argued here that it represents one of the reasons for the recentsub-prime crisis. In termsof thecauses of the sub-prime crisis, which pavedthe way for thebroader global financial collapse, the following can be seen as the most important:

. The tendency for low income (or “sub-prime”) US households to borrowexcessively from banks and finance companies to buy their homes and thendefault on their debt obligations.

. The sheer size of the sub-prime housing loan market – about US$1.4 trillion.

The growth in the market partly reflected the US Government’s attempts, since the1990s, to extend home ownership, which in turn placed pressure on mortgagelenders to increase loans to low- and moderate-income individuals and households(Hull, 2009).

. Wall Street financial engineers packaged these loans as highly complicatedfinancial instruments called collateralized debt obligation (CDO). As is now wellknown, The US and European markets invested heavily in these products.

As defaults on US home loans rose, the financial instruments that were based on theseloans lost value and CDO prices started plummeting. The falling prices in turn dentedbanks’ investment portfolios and the losses destroyed banks’ capital. Defaults onmortgage loans were the triggerfor thefinancial crisis sweeping the world. As thehousing

loan crisis intensified, banks grew increasingly suspicious about each others’ solvencyand the ability to honour commitments. The interbank market shrank and disrupted theflow of funds, which culminated in the problems in the global banking system.

3.2 Models and quantitative financeCDOs and credit default swaps (CDSs) were constructed by using complex modelsbased on restrictive assumptions. The house price defaults were estimated using pricesof CDSs rather than through more rigorous and complicated methods. The market was

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persuaded that the business cycle had changed, and a period of moderation wasexpected. The anticipated end to excessive volatility in economic output and inflationwas based on trends observed in the previous 20 years. When this prediction proved tobe untrue (with disastrous results), the realization came too late for many (Barrett,

2009). The players in the financial market (both new entrants and the more financiallyliterate) failed to understand the financial products, such as CDOs. Asymmetricinformation compounded the misjudgment.

A factor that unquestionably amplified the magnitude of the crisis’s impact was thewidespread miscalculation by banks and investors of the level of risk inherent in theunregulated CDO and CDS markets (Crisishelper, 2009). Accordingly, banks andinvestors systematised the risk by taking advantage of low interest rates to borrow largesums of money that they could pay back only if the housingmarket continuedto increasein value.

The Austrian School of Economics suggests that the crisis is an excellent example of the Austrian Business Cycle Theory, in which credit created through the policies of central banking give rise to an artificial boom, which is inevitably followed by a bust.This theory argues that the monetary policy of central banks creates excessivequantities of cheap credit by setting interest rates below where they would be set by afree market. This easy availability of credit inspires a bundle of malinvestments,particularly on long-term projects, such as housing and capital assets, and also spurs aconsumption boom as incentives to save are diminished; an unsustainable boom thusoccurs (Antony and Gregory, 2001).

3.3 Securitisation and misjudgment of riskThe securitisation of assets in the years prior to the crisis represented an attemptat managing risk; while this could be argued as being a prudent course of action,the specific financial instruments used contributed to the severity of the crash. Investors

considered derivatives, financial futures, CDSs and related instruments as a means of insuring against risk and, as they initially made more money by taking more risks,it reinforced their view that they had got it right. Therefore, banks and hedge fundsbecame over-confident and over-reliant on financial instruments for managing risk,wrongly thinking that they had spread their risks effectively whereas in fact whenthings went wrong, the effect was disastrous. Derivatives did not trigger the currentfinancial meltdown, but they did exacerbate it once the subprime mortgage marketcollapsed, because of the inter-linkages amongst investments.

The finance industry flourished as investors began examining how best to insureagainst risk. When considering how to price this insurance, economists came up with theoption of a derivative that gives someone the right to buy something in the future at aprice agreed in the present. Mathematical and economic experts believed they had

devised a formula for how to price such an option; the Black-Scholes model. This was ahit; once options could be priced,they became easier to trade and a whole new area of riskmanagement was born. Combined with rapid developments in information technology,the derivatives market exploded, making buying and selling of risk on the open marketpossible in ways never seen before. As people became successful quickly they usedderivatives, not to reduce their risk, but to take on more risk to make more money(Stiglitz, 2010). Greed started to compound and companies began venturing into areasthat were not necessarily part of their core business.

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The integrity of credit rating agencies is also under the spotlight, as it is partlyresponsible for the present crisis. Boyle (2009) argues that the issuer-pays model of ratings agencies encouraged the generous evaluation of subprime-linked securities andencouraged lenders to turn a blind eye to borrowers’ shortcomings. While credit rating

organisations have served investors and the market well for nearly a century, ratings onUS housing-related structured securities in recent years have, regrettably, generallyfailed to perform as well as intended (S&P, 2009). In this context, Hull and White (2009)examined whether assigned ratings were reasonable and found that AAA ratings forthesenior tranches of asset-backed securities (ABSs) were not unreasonable; however, theyconcluded that the AAA ratings awarded to senior tranches of mezzanine ABS CDOs aremuch less easy to defend.

3.4 Inadequate governance and regulationsA system of corporate governance requires that a board of directors be accountableto regulators, while allowing the board to create wealth for the shareholders of

the company. While recognising these twin objectives of a system of good corporategovernance, firms might usefully direct their attention towards issues of control andaccountability. It has been found that a far greater understanding of the links betweengovernance mechanisms and their effectson accountability and enterprise is required, inorder to ensure that measures to increase accountability do not have unforeseen effectson the enterprise activities of the corporation (Short et al., 2009).

WorldCom is a good example of inadequate corporate governance leading to anunexpected collapse. By 2001, WorldCom’s growth had started to decline, revenue beganto decrease, debts rose and, along with continued over-capacity, these changes forced thecompany into severe decline (Boyd, 2003). The stock value slipped from a double-digitfigure to US$0.50. Trading in WorldCom was stopped and, in June 2002, companyofficials confessed that the firm had inflated its profit by improperly accounting formore

than US$3.9 billion[1]. A detailed investigation further revealed that: accounting entrieswere made without documentation (as directed by the senior management of thecompany), profit was reported in times of losses, executives filed statements to the SECthat treated current expenses as capital and manipulation of specific reserves weredetected from the books of WorldCom. Financial experts have pointed out thatWorldCom’s accounting practices, particularly those relating to the acquired businesses,made it impossible for investors to gauge the performance of the company (Zekany etal.,2004). Revisions of financial statements were thus the norm in WorldCom. Whileprofitability was overstated, investors were misled by the opaque nature of its regularoperating performance.

3.5 Fair value and accounting standards

International Financial Reporting Standards (IFRS) and US Generally AcceptedAccounting Principles define the fair value of financial instruments in a three-levelframework:, i.e. the observable market price of the instrument, or the observable marketprice of a similar item or the result of a financial valuation model. The IASC’s frameworkfor the preparation and presentation of financial statements views fair value asreflecting relevance, reliability, understandability and comparability (Chisnall, 2001).The ongoing financial crisis has caused much finger pointing at fair value accountingfor financial instruments, as set out in IFRS and US GAPP, particularly IAS 39.

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Prominent financial leaders singled out fair value and the related wide use of mark-to-market accounting as major factors in the crisis. In this context, fair valueaccounting has prompted two specific criticisms: illiquidity and pro-cyclicality. Theilliquidity criticism focuses on complex products resulting from the securitisation

of assets, such as mortgage loans, which are at the core of the current financial crisis.The illiquidity criticism notes that the market conditions for many complex financialinstruments are characterized by an imbalance between supply and demand, whichmeans that market prices are rendered abnormal by the evaporation of liquidity and,as such, may bear no relation to the underlying value defined as the potential to generatefuture cash flows. The pro-cyclicality criticism is broader in scope; according to it, thevery idea that observable market prices provide the best possible indication of value isflawed because it boosts the apparent robustness of banks’ balance sheets at the top of the cycle and reduces it by the same measure at the bottom (Veron, 2008).

The factors outlined above are of course only a few of the numerous contributors tothe GFC. In particular, we argue that the excessive greed, allied to the dominance of theSWM had a significant impact on the crisis. The next section explores this issue by

reviewing relevant extant case studies and prior studies.

4. Side effects of the corporate objective function of SWMCorporate finance’s greatest strength and its greatest weakness are its single-mindedfocus on value maximisation (Damodaran, 1999). Every firm tries to achieve thiscorporate objective through careful planning and the implementation of investment,financial and dividend decisions. Had all boards of directors being successful in theirassigned role of protecting all stakeholders of the firm, rather than just shareholders,then we believe that the GFC would have been avoided.

Most business concern is focused on profit maximisation. However, profitmaximisation fails for a number of well-known reasons; it ignores:

(1) the timing of returns;(2) the cash flows available to shareholders; and

(3) risk.

Without explicitly considering these factors, higher earnings alone do not necessarilytranslate into higher share prices (Gitman et al., 2008, p. 13).

4.1 Conflict between shareholders and bondholdersThe most common ways that managers take action to achieve SWM at the cost of bondholders are: investing in risky projects, paying more dividends and increasingfinancial leverage. If the executives are also shareholders then there may be a furthertendency for them to want to maximise shareholder wealth, which could be detrimentalto the bondholders (Ertugrul and Hegde, 2007). In the recent past, there have been amplecases of related party transactions, insider trading and other attempts to expropriatefunds for the benefit of shareholders. For example, the US Securities and ExchangeCommission (2010) allege that Goldman Sachs failed to disclose to investors vitalinformation about CDOs, with Paulson & Co., having an economic incentive to selectresidential mortgage-backed securities. Capital and Merchant, a New Zealand financecompany, disclosed $10 million of related party loans on the balance sheet but furtherinvestigation by the receivers uncovered $80 million of related party loans that were not

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disclosed and unrecoverable. St Laurence Limited suffered a similar fate with itsabundance of related party loans, including substantial transactions between itself andDorchester Finance Limited.

Shareholders carry more risk than bondholders because they are entitled to the

profits remaining only after all other stakeholders and creditors are paid. If nothing isleft, they do not receive any return as they are the “residual” claimants of a company’sprofits. If a company generates large profits, shareholders enjoy the highest returns.Meanwhile, lenders keep receiving the same interest payment year in and year out,regardless of the level of company profits. By contrast, owners keep whatever profitsare left over and therefore can receive a greater return on their capital.

“Shareholders lose value before bankruptcy; bondholders hurt much more inbankruptcy than shareholders” (Ross et al., 1996). This statement is especially true incurrent market conditions. While the traditional goal of the firm is MSW, this should occurwhile being ableto meet its financial commitments, including repayments to bondholders;such an approach provides the best results for both shareholders and bondholders. Morerecently, the steep drop in the value of Citibank’s bonds indicates fears that the USGovernment will take over the institution and compel bondholders to take big losses.The Managing Director of Institutional Risk Analytics, Christopher Whalen, argues that:“It’s a done deal that Citibank shareholders would be wiped out completely innationalization but bondholders could also be in for a real whacking” (Elestein, p. 1).

TheAustralianShareholder’s Association (2005)states that the basic expectation of theshareholders is the generation of maximum cash flows and profit, while the bondholder’sexpectation is always the committed cash flows. “Bondholders’ reasonable expectationsare held to be more limited than those of shareholders, and should be limited to terms of trust indenture and prospectus” (Hewat and Richler, 2009). There are covenants whichrestrict actions that shift risk to bondholders, and also to compensate them withaccelerated rates of interest, with every increase in the risk component. Even amidst these

restrictive covenants, managers/agents find ways to shift risk from shareholders tobondholders and thus increase the value of shares at the expense of bonds.Even though conflict between shareholders and bondholders is one of the side

effects of the pursuit SWM, it is less clear that this conflict has contributed to thepresent crisis directly. However, as noted above, excessive greed has contributeddirectly or indirectly to the dysfunctional behaviour and institutional failures at theheart of the global crash.

4.2 Agency issueDamodaran (1999) explains that, in the real world, managers perform the decision-makingfunction with four factors or linkages in mind: shareholders, bondholders, society andfinancial markets. Competitivemarket conditions place significant pressure on agents and

managers who will be tempted to resort to unethical means to portray a positive picture.It is acknowledged thatthe wealth maximisationobjective is not always compatiblewith afirm’s social obligations, and it usually involves an agency problem which arises when themanagers fail to act in the best interests of the shareholders, preferring instead to benefitthemselves ( Jensen and Meckling, 1976).

Differences in the objectives of ownership and management lead to agency costs;if these are to be controlled, the shareholders must maintain a strict watch over thefunctioning of the company. Themanagers should be rewarded foracting in the interests

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of the shareholders and the managers should maintain a balance between the interestsof the shareholders and other stakeholders. In this context, the GFC highlighted theimportant influence that incentive structures within financial institutions and otherbusinesses can have on risk-taking and financial performance. In particular,

it highlighted the dangers of badly designed remuneration incentive arrangementsleading to excessive risk-taking, poor financial performance and a bias towardsshort-term results at the expense of longer-term financial soundness (Mortlock, 2009).

4.3 Executive compensation and inappropriate incentivesIt is well documented that executive compensation packages should be designed to alignthe interests of senior management with those of the shareholders and thereby reducethe dysfunctional behaviour of managers; this is typically done by rewarding executivesfor taking decisions and actions that increase shareholder wealth (Mortlock, 2009).Unfortunately, the shareholders (and directors) may have neither complete informationabout the actions of executives or the expertise to evaluate those actions, making it

difficult to base compensation on actions alone. Instead, compensation in practice isoften linked to measures that are positively correlated with managerial performance,for instance market share, share price or accounting profit.

The World at Work (2007) Handbook discusses the various components of executivecompensation packages, such as base salary, bonus, perquisites, stock options, stockgrants, pensions and severance payments. These components have varying effects onexecutive motivation and risk, and also different costs for the corporation. Consequently,stock options became an ever greater part of executives’ compensation, “increasing from27 per cent in 1992 to 60 per cent in 2000” (Smith and Russell, 2003).

The fixing of base salaries for executives is often guided by the salaries paid to peersin the same industry. A fixed salary will reduce the risk to the executives and guarantee astandard of living. On the other hand, it may not encourage them to improve their

performance in order to maximise shareholder wealth. The use of golden handshake andgolden parachute clauses in management contracts may also be driven by managersacting to further their own interests, rather than those of their shareholders.

Matsumura and Shin (2005) characterized conflicts of interest between shareholdersand managers as usually arising in three broad areas. First, executives enjoy (as wellas exploit) the perquisites provided to them. Second, executives are more risk averse indecision making and aim for better compensation as a trade-off. Lastly, executives aremore interested in making decisions that have short-term impacts rather than taking along-term perspective. By designing executive packages in a way that balances theinterests of shareholders and executives, these conflicts can be reduced. The packagesshould be so designed to motivate the executives, whilst at the same time allowingmanagement to control the amount spent on compensation, based on the performance

of the CEOs themselves. Mortlock (2009) notes that the major financial and corporatesector distress seen in the USA and Europe in recent times is partly attributable topoorly designed remuneration incentive arrangements.

4.4 Ethics and social responsibilityWhile emphasising SWM, the principle of ethics and its impact on the value of the firm isdisregarded in manyinstances. The importance of ethics in the corporate decision-makingprocess becomes important in view of the sheer number of stakeholders involved.

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It should come as no surprise that the advocates of wealth maximisation uphold theprinciple of utilitarianism – in essence, an ethical version of maximisation.Fundamentally, the professional viability of ethical principles themselves is at stake.By definition, ethics involve the consideration of right and wrong in decision making and

policy formulation. At the same time, it should be clear that the financial maximisationprinciple itself offers no real ethical guidance in a corporate governance context (Halbertand Ingulli, 2008). However, research conducted by Van de Velde et al. (2005) concludedthat socially responsible companies out-performed non-socially responsible companies,although the difference was not significant. Evidence of this sort suggests that beingsocially responsible is advantageous to investors’ wealth in the vast majority of cases.

The economic welfare of shareholders is a matter of prime concern to every corporateentity. According to conventional economic reasoning, corporations have a specified setof responsibilities – primarily to maximise shareholders’ wealth – while functioningefficiently under conditions of perfect competition. However, the situations of imperfectmarkets and information asymmetries have become extremely significant in the presentclimate. Many academicians consider the firm as an input-output model by explicitlyadding all interest groups – employees, customers, dealers, the government and societyat large. Therefore, it becomes imperative to identify and label the pertinent factorswhich contributed to the financial crisis and to identify the role of the SWM’s theme inthis regard.

4.5 Efficiency and fairness in financial marketsIn order to achieve growth in the global economy, financial markets should be efficientand fair. The concern with efficiency and fairness has led to various schemes of financialmarket regulation being suggested. Debate about efficiency and fairness, and the roles of market forces and regulations, reveals a continuing attempt by society, through itslegislative process, to find the right balance of these elements. Informational efficiency is

achieved when all investors hold objective beliefs and information in common, so thatcompetitive prices accurately reflect that information.Shefrin and Statman (1993) held “that in a fair market, all parties have equal access to

information relevant to asset valuation, but are entitled to nothing more”, as well asspeaking of informational efficiency as being achieved when all investors hold objectivebeliefs and information in common. Included in Shefrin’s description were seven classesof financial market fairness: freedom from coercion, freedom from misrepresentation,equal information, equal processing power, freedom from impulse, efficient pricesand equal bargaining power. As noted above, the cases of Enron and WorldCom provideevidence that unfair and inefficient information are strong enough to shake the wholefinancial system. However, the manipulation of accounting figures has a long history inthe developed world, and governments the world over have tried to introduce order and

transparency to the functioning of companies and capital markets. When the company isindulging in any type of artificial stock market manipulations it is often the smallinvestor who is enticed into this speculative trading and eventually loses when thecollapse begins.

4.6 Corporate greed and creative accounting Creative accounting is the manipulation of financial numbers, usually within the letter of the law and accounting standards, although its use can be unethical and does not

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provide the “true and fair” view of a company that accounts are supposed to provide(Moneyterms, 2009). As detailed below, many of the recently failed companies usedcreative techniques to mislead current and potential investors. Whether through incomesmoothing, inflating profits, manipulating assets and liabilities, derivatives and hybrid

instruments or off balance sheet financing, the financial positions of many companieswere distorted so that they were seen in a favourable light, thereby encouraging furtherinvestment and facilitating continued trading.

In December 2001, Enron, one of the world’s largest electricity and natural gastraders, filed for Chapter 11 bankruptcy protections. The CEO, Kenneth Lay, persuadedthe employees of Enron to buy the company’s stock. Just three weeks later Enronreported a heavy loss and drift in shareholders’ equity. Employees lost their retirementand other savings tied up in Enron shares, as well as their jobs. It was later discoveredthat Mr Lay had made US$205 million in stock option profits in the previous four years.Many banks were exposed to the firm, having loaned money and traded with it; forexample, JP Morgan admitted to US$900 million of exposure and Citigroup to nearlyUS$800 million. Former high-ranking Merrill Lynch bankers were charged with fraudin connection with Enron transactions, while the auditors Arthur Anderson, who failedto audit the Enron books correctly, collapsed. Enron’s collapse, in conjunction with thefailure of several hitherto popular and famous corporations, severely shook investors’confidence, with many becoming cynical about the financial data reported bycorporations, even when audited by big firms.

An examination of history reveals that a range of practices, unrelated to any majorimprovement in cash flows and/or profits, have been carried out with the intention of increasing wealth; for example: accounting manoeuvres with deceitful intention andaccounting fraud (in the case of Xerox), improper accounting, deviation from accountingprinciples with deceitful intention, leveraging of shares to raise debt for expensiveacquisitions (as in the case of WorldCom), stretching the limits of accounting by

misusing its limitations, lack of transparency, intentional projection of a “rosy” pictureof performance (in the cases of Enron and Arthur Anderson), massive fraud, accountingscandal (in the case of Peregrine Systems), aggressive acquisition strategies andaccounting frauds (in the case of Tyco), diverting business cash into off-shore,family-owned entities, artificial support given to the stock of the company (in the case of Polly Peck), deceitful intention of elite and experienced hands with sophisticated outlets(in the case of BCCI banks) and highly leveraged synthetic financial instruments (in thecase of Goldman Sachs).

Common to all the cases mentioned above was management’s single-minded focus onSWM. By attempting to grow thecompanyat high speedand by using creative accountingtechniques, managers had failed to foresee the detrimental affect these actions would havein the long term. In this regard, and building on the aggregated material outlined in

Sections 3 and 4, the next section develops the argument that one of the causal influenceson the GFC was indeed a corporate objective function dominated by SWM.

5. DiscussionDamodaran (1999) stated that the SWM objective is based on the following fourassumptions. First, all costs created by a company in pursuing SWM can be traced andcharged to the firm. Second, the interest of all lenders and bondholders will beprotected. Third, the managers of the company disclose all relevant information about

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the company’s future prospects to the financial markets. Lastly, the managers set asidetheir personal objectives and focus on the corporate objective function.

It is clear that, in light of the side effects of SWM as discussed in Section 4 – particularly their impact during the crisis – the validity of the above assumptions has

become questionable. In this regard, Jenkins and Guerrera (2010) argue that the recentSEC attack on Goldman Sachs strikes at the heart of the business model, a model that,as Friedman (1970) states, views the social responsibility of business being to increaseits profits. However, as an agent, a manager is bound to act to maximise the wealth of shareholders, rather than to follow an agenda of social responsibility, this is evident inthe cases and other supporting literature cited in Section 4.

As noted earlier in the paper, the origins of the credit crisis can be found in the UShousing market; more specifically, the root cause lies with the problem that, whenconsidering new mortgage applications the question was not, “Is this credit we want toassume?” but was instead: “Is this a mortgage we can make money on by selling it tosomeone else?” (Hull, 2009). This reasoning clearly illustrates that the flaws in the SWMapproach, allied with greed of the mortgage brokers and mortgage lenders, motivatedthem to relax their lending standards (Stiglitz, 2010).

The fraudulent behaviour of chief financial officers was sometimes motivated by theSWM-based corporate objective function and it brought about a hasty governmentreaction. The Sarbanes-Oxley Act of 2002 (SOX) was enacted by the US congress on30 July 2002; SOX reformed US accounting rules and put in place a new regulatory bodywhich was independent of audit firms (Arrunada, 2004). This sweeping reform requiredthat a company strengthen auditor independence, have its CEO sign off on financialstatements, obtain an opinion about its internal control systems and have its internalaudit function examined by external auditors (Grumet, 2007). The introduction of SOXshould reduce managerial propensity to use creative accounting techniques to enticeinvestors in the difficult post-crisis years.

From the case studies cited in this paper, it is clear that major issues like unethicalbehaviour, executive compensation, creative accounting and conflicts of interest, pushedthe big entities towards major difficulties and, in many cases, collapse. Though a seriesof accounting regulations were designed and directed, many giant organisations foundconvenient loopholes to take advantage of or, if this was not possible, resorted tomanipulative means, actions which ultimately contributed substantively to the financialcrisis.

Hull (2009) argues that the inappropriateness of extant incentive schemes led to ashort-termfocus in themanagerialdecision making. Given thissituation, in February 2009,US President Barack Obama introduced new restrictions on executive compensation forinstitutions that receive financial assistance from the government, by limiting cashcompensation to US$500,000; similarly, the US’sFinancial Stability Board released a set of

principles aimed to ensuring effective governance of compensation and the effectivealignment of compensation with prudent risk taking. These developments in turn suggestthat the SWM objective is neither self-regulatory nor flawless in nature.

As we have discussed in this paper, the reasons for the burst of this financial bubbleare many. However, most of the factors are (directly or indirectly) linked to the pursuitof SWM. The above discussion has shown that each factor had in common the desire toincrease the value of owners’ wealth. It appears reasonable to argue that, by forgettingthe importance of ethics and deviating from accounting principles, the greed paid off.

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6. Summary and conclusionsExcessive greed, obsolete accounting standards, conflict between accounting andconsulting, rendering of non-audit services and retired auditors sitting on boards of companies were identified as vital issues contributing to financial misbehaviour, which

led in turn to the financial crisis at the micro as well as the macro level. However, if theabove anomalies, problems and incidents can be subjected to robust governancestandards, it may help to minimise the gravity of the problem. In the opinion of Stephen Roach, we need a global systemic risk regulator as part of a broader movetowards risk management. Risk shifting and dysfunctional behaviour are some of the side effects and flaws in an SWM-based system that is not self-regulatory.Maino et al. (2010) argue that the philosophy of efficient and self-correcting marketsand intermediaries in the global financial system represents one of the main causes of thecrisis; this logic underpins our view that the SWM objective had a major influence on thecrash. However, the degree of influence depended partly on the government regulatoryenvironment and economic system; thus the argument is not equally valid universally.

The collapse of Arthur Andersen in the wake of accounting manipulations found inEnron, along with the events at WorldCom, Waste management, Sun Beam, etc. havecaused investors to raise serious concerns about the reliability of modern auditing.However, the events at Enron and Andersen resulted in several positive outcomes;a number of corrective measures were initiated worldwide to counteract corporate fraud.Indeed, many corporate governance and accounting reforms were enacted in the USA inthe wake of the collapse, followed by similar reforms worldwide. The Sarbanes-OxleyAct brought in stiff penalties for violation of US securities laws. Again, we argue thatthe root cause of this manipulative and dysfunctional behaviour was greed and thesingle-minded objective function of SWM.

Because of a strong focus on profit maximisation or even SWM, the corporatedecisionsthatledto the economic downturn were never balanced withany “good citizen”

approach. But value maximisation alone is no longer sufficient in today’s competitiveglobal business environment; organisations need to focus on objectives that havelong-term benefits rather than short-term value. By taking stakeholders and society intoconsideration a firm will truly begin to create sustainable wealth; while the corporateobjective function is dominated by SWM this cannot take place.

Note

1. The Department of Justice identified a further US$3 billion as improperly recorded.

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Corresponding authorNoel Yahanpath can be contacted at: [email protected]

To purchase reprints of this article please e-mail: [email protected] visit our web site for further details: www.emeraldinsight.com/reprints

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