12.1 Borrowing and lending problems in nancial intermediation

The signicance of the EMH is that there are no bargains to be had in the takeover

or acquisitions market. That is to say, there will be no rms whose price is depressed

by virtue of the failure of the market to recognise the value of future earnings,

however far in the future they may lie. There will be companies whose share price

is low. But this will be because their underlying assets are unproductive. This may

be because of unwise decisions in the past or a change of market circumstances to

which the management has failed to react, or the result of any one of countless other

causes. With a low share price, such rms will be takeover targets for other rms

whose managers think they can do better. But these will not be ‘bargains’; they will

be correctly priced. And their takeover by superior management is just what one wants

in an efciently functioning capital market. In these circumstances, the takeover is

the mechanism for improving the allocation of managerial skill and eventually the

allocation of capital resources.

If we were to conclude that the UK’s economic performance was poor because of

a focus upon short-term investment decisions by rms, a number of potential remedies

suggest themselves, though none is without difculties.

If the problem lies with rms themselves rather than with the nancial system,

the remedy would seem to lie in either giving managers a different (longer-term) set

of incentives or giving more power to groups with longer-term interests. In recent

years it has become quite common for senior managers, with large corporations

at least, to have their salaries or bonuses linked to the behaviour of the rm’s share

price. However, the test of success is usually what has happened to the share price

in the past year or two. If, by contrast, managerial remuneration were linked to

the value of the rm averaged over, say, a ve to seven-year period, managers would

have more incentive to look to the long-term performance of the rm. More power

for non-executive directors, whose remuneration is not linked to the performance of

the rm, is another possibility. It does not follow automatically that they would take

a longer-term view of investment plans, but it is arguable that they are as interested

in long-term performance as in the short term.

Shareholders too might be encouraged to take a more active role in management.

In practice, this would require institutions (since they are the major shareholders)

to take a more active role. Whether they would wish to do this is another matter.

They would need to hire additional staff with appropriate skills who would then

be voted onto company boards. This would involve additional expense and it

might also cause difculties under the existing legislation which prohibits ‘insider

dealing’. As the law stands, an NDTI which had a paid representative on the board

of a company could be accused of having inside information about the rm and

would then be barred from trading in the shares of the rm. This rather defeats the

purpose.

If one thinks that short-termist behaviour is forced upon rms by the nancial

system, the remedy must lie with innovations which slow down or discourage the

frequent trading of shares in a company. This is often described as putting ‘sand

in the wheels’ of the system. Giving the Competition Commission greater powers to

prevent takeovers and mergers is one suggestion. At the moment, the Commission

is mainly concerned with what a merger will do to competition and consumer choice.

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Chapter 12 • Financial market failure and nancial crises

The criteria for making such a judgement are reasonably straightforward: statistical

measures of market concentration are available. It is much more difcult to lay down

criteria for judging whether a proposed merger is against the long-term interest of

innovation and productivity in a rm. Another proposal involves a tax on the trad-

ing of shares. This would put up the cost of each transaction and, it is argued, make

traders more inclined to hold shares for a longer period. The arguments against this

are that if it were imposed in one national market, share dealing would be diverted

to centres where the tax was lower or non-existent; reducing the volume of trading

reduces the liquidity of shares and may lead shareholders to demand higher returns

for holding them; a reduction in the volume of dealing means also that there are

fewer buyers and sellers at any particular time and this may mean that prices will

uctuate more than they currently do. Putting sand in the wheels may have some

merit, but the benet seems bound to come only with a reduction in the efciency

of the equity market.