Do banks need belts and braces? – Bank Underground

Some interesting research via a Bank of England Staff Working Paper that explores the value of using multiple regulatory constraints to measure the risk of failure in banks.

Not surprisingly, they find superior utility in a portfolio of measures (risk weighted capital ratio, leverage ratio and Net Stable Funding Ratio) versus relying on a single measure of risk. This is not just due to better predictions of potential for failure but also because this is achieved at lower threshold ratios than would be the case if any of the measures was the sole basis for indicating heightened risk of failure

— Read on bankunderground.co.uk/2021/02/16/do-banks-need-belts-and-braces/

Tony – From the Outside

JP Koning – What Tether Means When It Says It’s ‘Regulated’ – CoinDesk

Useful article on Coindesk discussing what underpins the integrity of one of the more popular forms of Stabecoins

“Newcomers to the crypto space are quickly confronted with a popular distinction between regulated stablecoins and unregulated stablecoins. But what is the difference? Tether, the largest of the stablecoins, is often described as unregulated. But Tether executives and supporters disagree with this claim. Who is right?”
— Read on www.coindesk.com/what-tether-means-when-it-says-its-regulated

I don’t profess any real insight or expertise in this space but it does feel to me like a question that any serious student of banking needs to come to terms with.

Tony – From the Outside

Australian bank capital adequacy – “a more flexible and resilient capital framework”

This post looks at a Discussion Paper published by APRA in late 2020 titled “A more flexible and resilient capital framework for ADIs” setting out how it proposes to wrap up a number of prior consultations on a variety of aspects of ADI (authorised deposit-taking institution) capital reform in Australia. The next step in the roll out of the revised framework is to conduct a quantitive impact study (QIS) with selected ADIs to ensure that the proposed final standards are appropriately calibrated.

Key elements of the revised framework (effective 1 January 2023) include:
  • More risk-sensitive risk weights (mostly for residential mortgages but also SME lending) that are expected to reduce average risk weights by approximately 10% for Internal Ratings Based (IRB) banks and 7% for banks operating under the Standardised Approach (SA) to capital adequacy,
  • Support for enhanced competition between the big and small ADIs via a series of initiatives intended to limit the differences between the IRB and SA, approaches (though APRA also offers evidence that the existing differences are not as great as some claim),
  • Improved transparency and comparability both with international peer banks and between the big IRB banks and the smaller SA banks
  • Improved flexibility in capital requirements via an increase in the size of regulatory capital buffers.
Improved risk sensitivity (lower risk weights)

Improved risk sensitivity is obviously a two edged sword (capital requirements could increase) but APRA estimates that the overall impact of the proposed revisions will be to reduce average risk weights for IRB ADIs by 10% and by 7% for Standardised ADIs. I have published a couple of posts already on the proposed changes to residential mortgage risk weights (see here and here) so I don’t intend to cover that in any detail in this post.

The main points to note regarding residential mortgages are:

  • Standardised ADIs get
  • IRB ADIs see
    • the higher than Basel “correlation adjustment” currently used to narrow the difference between IRB and SA risk weights replaced by a simple “scalar” adjustment,
    • the existing 20% LGD floor reduced to 10% for approved LGD models and
    • recognition of the risk reduction value of Lenders’ Mortgage Insurance (LMI) in line with the SA.

I have not looked closely at the changes impacting the other RWA exposures but list them here for completeness:

  • SME lending
    • Standardised ADIs – RW applied under the SA will recognise the value of commercial property security while RW for loans not secured by property will be reduced from 100% to 75% for loans less than $1.5m and 85% otherwise
    • IRB ADIs – the thresholds for applying the Retail SME approach and the Corporate SME approach will be increased
  • Other credit portfolios
    • Standardised ADIs see no real change (existing RW are already largely aligned with the Basel framework)
    • IRB ADIs will see the overall credit scalar in the IRB RW formula increased from 1.06x to 1.1x, risk estimates will be more closely aligned to those of overseas peers (but still higher than those peers) and models will be permitted for the calculation of capital requirements for commercial property exposures
  • New Zealand based exposures
    • RWA determined under RBNZ requirements will be used for group capital requirements
Enhanced competition, increased transparency and comparability

The main points to note here are:

  • The risk weight initiatives listed above should address a long standing complaint from the Standardised ADIs that the higher risk weights they are subject to place them at a competitive disadvantage relative to IRB ADIs
  • Note however that APRA has also provided evidence that the difference in capital requirements is not as large as is often claimed and can be justified by differences in the risk of the loan portfolios that different types of ADIs typically hold
  • The extent of any competitive disadvantage due to capital requirements will be further clarified by the requirement that IRB ADIs also publish capital ratios under the Standardised Approach
  • The extent of the differences between the capital requirements applied by APRA and those used to calculate the ratios reported by international peer banks will also be reduced thereby enhancing the transparency of the Australian ADI capital strength versus the international peer groups. This will make the “top quartile” test employed to determine the “unquestionably strong” benchmark simpler and more transparent.
Increased resilience via larger more flexible capital buffers

We noted above that RWA are expected to reduce by around 10 per cent on average for IRB banks and 7 per cent on average for standardised banks. All other things being equal this will translate into a very visible increase in reported capital ratios which requires a recalibration of the balance between minimum requirements and capital buffers:

  • The minimum Prudential Capital Requirement (PCR) remains unchanged in percentage terms (4.5%), as does the minimum threshold for Point of Non-Viability (PONV) conversion (5.125%), but these requirements fall in dollar terms due to the decline in average RWA
  • The Capital Conservation Buffer (CCB) – will be increased by 150 basis points (but only for IRB ADIs)
  • The default Countercyclical Capital Buffer (CCyB) – will be set at 100 basis points (versus zero under the current approach)

Minimum capital requirements

At face value, a reduction in minimum capital requirements sounds like a cause for concern. In theory you can argue that there is a slightly lower amount of CET1 capital available in a scenario in which a bank has breached the PONV threshold that triggers the conversion of Additional Tier 1 and any other layers of loss absorbing capital. In practice, however, this theoretical risk is more than offset by the increase in the CCB and the CCyB. APRA is at pains to emphasise that, all other things being equal, the dollar value of capital that ADI’s currently hold consistent with the Unquestionably Strong benchmarks introduced in 2017 does not change under the revised framework.

With amendments across a number of dimensions, reported capital ratios will inevitably change … However, APRA remains committed to its previous position that an ADI that currently meets the ‘unquestionably strong’ benchmarks under the current framework should have sufficient capital to meet any new requirements. Changing the presentation of capital ratios will not impact overall capital strength or the quantum of capital required to be considered ‘unquestionably strong’; but instead improves comparability, supervisory flexibility and international alignment.

“A more flexible and resilient capital framework for ADIs, APRA Discussion Paper, 8 December 2020 (page 5)

In addition to the increased base levels of CET1, the systemically important ADI are holding increasing amounts of “Additional Loss Absorbing Capital” that can be bailed-in to create CET1 capital in the event that a bank is at risk of breaching the PONV threshold. There are differences of opinion on whether APRA would be willing to pull the trigger to convert these instruments. We won’t know for sure until the time comes, but my colours are nailed to the assumption that APRA will much prefer to see shareholders get diluted rather than having to use government funds to bail-out a bank.

Capital Conservation Buffer

The 150bp expansion in the CCB only applies to IRB ADIs. APRA attributes this to the need to respond to “the greater level of risk sensitivity inherent in the IRB approach” (page 16 of the Discussion Paper). They don’t actually use the term but I think of this as a means of absorbing some of the pro-cyclicality that is inherent in any risk sensitive capital adequacy measure.

A simple way to think about this change is to link the 150bp increase to the roughly equivalent benefit of the 10% decline in RWA expected to flow from RWA changes set out in the paper. We note however that SA gets 7% decline due to improved risk sensitivity but no equivalent increase in CCB. So we get enhanced risk sensitivity in the IRB approach via the revised risk weights without exacerbating the concern about the difference in capital requirements.

However the increased risk sensitivity of the IRB approach also manifests in heightened sensitivity to an economic downturn. All other things being equal both Standardised and IRB ADIs should face similar increases in loan loss charges. The impact on IRB ADI capital ratios is however amplified by the increase in average RWs under stress. I don’t have any hard data to refer to but would not be surprised if the RWA inflation effect contributed another 150bp to the decline in capital ratios we see quoted in stress testing results under this new framework.

Viewed from this perspective the expanded CCB not only neutralises the benefit of lower IRB risk weights, it also helps absorb the increased sensitivity to declines in capital ratios that IRB ADIs can be expected to experience under a stress scenario.

Counter-cyclical Capital Buffer

The CCyB has, for me at least, always been a sound idea badly executed. It became part of the international macro prudential toolkit in 2016 and is intended to ensure that, under adverse conditions, the banking sector in aggregate has sufficient surplus capital on hand required to maintain the flow of credit in the economy without compromising its compliance with prudential requirements.

A key feature in the original Basel Committee design specification is that the buffer is intended to be deployed in response to high levels of aggregate credit growth (i.e high relative to the sustainable long term trend rates whatever that might be) which their research has identified as an indicator of heightened systemic risk. That does not preclude bank supervisors from deploying the buffer at other times as they see fit, but pro-actively responding to excess credit growth has been a core part of the rationale underpinning its development.

The idea of having a buffer that can be released in response to a downturn makes perfect sense but the analytical structure the Basel Committee developed to guide its deployment seems unnecessarily complex. The simple non-zero default level that APRA proposes to adopt is arguably a better (if not the best) approach and one that other countries are already pursuing (see here, here and here).

None of this pro-cyclicality benefit is spelled out in the material APRA released so I may be reading too much into the material. If I am analysing it correctly if is a subtle but still useful benefit of the package of changes that APRA is pursuing.

Conclusion

Broadly speaking, I think there is a lot to like in the revised framework that APRA is pursuing

  • Risk weights that are both more risk sensitive but also more closely aligned under the two approaches to capital adequacy measurement (IRB and Standardised)
  • An increased share of the capital requirement allocated to buffers that can be used rather than minimum requirements that can’t
  • A better approach to setting the CCyB

My primary concern is that the amplified pro-cyclicality in capital ratios that is seemingly inherent in any risk sensitive capital framework seems likely to increase but there is very little discussion of this factor . There are tools to manage the impact but one of the key lessons I have taken away from four decades in this game is that the markets hate surprises. Far better to quantify the extent of any amplified pro-cyclicality in capital ratios prior to the next crisis than to try to explain the impacts when capital ratios start to decline more quickly than expected during the next downturn/crisis.

Let me know what I am missing …

Tony – From the Outside

Some of the backstory

The idea that Australian banks needed to be “Unquestionably Strong” has dominated the local capital adequacy discussion for the past few years. The idea originated in a recommendation of the Australian Financial System Inquiry (2014) based on the rationale that Australian banks should both be and, equally importantly, be perceived to be more resilient than the international peers with which they compete for funding in the international capital markets.In July 2017, APRA translated the FSI recommendation into practical guidance in an announcement supported by a longer information paper.

For most people, this all condensed into a very simple message, the systemically important Australian banks needed to maintain a Common Equity Tier 1 ratio of at least 10.5%. The smaller banks have their own Unquestionably Strong benchmark but most of the public scrutiny seems to have focussed on the larger banks.

In the background, an equally important discussion has been playing out regarding the extent to which the Unquestionably Strong framework should take account of the “comparability” and “transparency” of that measure of strength and the ways in which “flexibility” and “resilience” could be added to the mix. This discussion kicked off in earnest with a March 2018 discussion paper (covered in more detail here) and has come to a conclusion with the December 2020 release of the APRA Discussion Paper explored in the post above.

Dee Hock, the Father of Fintech

Marc Rubinstein writing in his “Net Interest” newsletter has a fascinating story about the history of Visa. The article is interesting on a number of levels.

It is partly a story of the battle currently being played out in the “payments” area of financial services but it also introduced me to the story of Dee Hock who convinced Bank of America to give up ownership of the credit card licensing business that it had built up around the BankAmericard it had launched in 1958. His efforts led to the formation of a new company, jointly owned by the banks participating in the credit card program, that was the foundation of Visa.

The interesting part was that Visa was designed from its inception to operate in a decentralised manner that balanced cooperation and competition. The tension between cooperation (aka “order”) and competition (sometimes leading to “disorder”) is pervasive in the world of money and finance. Rubinstein explores some of the lessons that the current crop of decentralised finance visionaries might take away from this earlier iteration of Fintech. Rubinstein’s post encouraged me to do a bit more digging on Hock himself (see this article from FastCompany for example) and I have also bought Hock’s book (“One from Many: VISA and the Rise of Chaordic Organization“) to read.

There is a much longer post to write on the issues discussed in Rubinstein’s post but that is for another day (i.e. when I think I understand them so I am not planning to do this any time soon). At this stage I will just call out one of the issues that I think need to be covered in any complete discussion of the potential for Fintech to replace banks – the role “elasticity of credit” plays in monetary systems.

“Elasticity of credit”

It seems pretty clear that the Fintech companies offer a viable (maybe compelling) alternative to banks in the payment part of the monetary system but economies also seem to need some “elasticity” in the supply of credit. It is not obvious how Fintech companies might meet this need so maybe there remains an area where properly regulated and supervised banks continue to have a role to play. That is my hypothesis at any rate which I freely admit might be wrong. This paper by Claudio Borio offers a good discussion of this issue (for the short version see here for a post I did on Borio’s paper).

Recommended

Tony – From the Outside

The potential for computer code to supplant the traditional operating framework of the economy and society

I am very far from expert on the issues discussed in the podcast this post links to, I am trying however to “up-skill”. The subject matter is a touch wonky so this is not a must listen recommendation. That said, the questions of DeFi and cryptocurrency are ones that I believe any serious student of banking and finance needs to understand.

In the podcast Demetri Kofinas (Host of the Hidden Forces podcast) is interviewed by two strong advocates of DeFi and crypto debating the potential of computer code to supplant legal structures as an operating framework for society. Demetri supports the idea that smart contracts can automate agreements but argues against the belief that self-executing software can or should supplant our legal systems. Computer code has huge potential in these applications but he maintains that you will still rely on some traditional legal and government framework to protect property rights and enforce property rights. He also argues that it is naïve and dangerous to synonymize open-source software with liberal democracy.

I am trying to keep an open mind on these questions but (thus far) broadly support the positions Demetri argues. There is a lot of ground to cover but Demetri is (based on my non-expert understanding of the topic) one of the better sources of insight I have come across.

Tony – From the Outside

Low Risk Residential Mortgage Risk Weights

I have posted a number of times on the question of residential mortgage risk weights, either on the general topic of the comparison of the risk weights applied to the standardised and IRB ADIs (see here) or the reasons why risk weights for IRB ADIs can be so low (see here).

On the question of relative risk weights, I have argued that the real difference between the standardised and IRB risk weights is overstated when framed in terms of simplistic comparisons of nominal risk weights that you typically read in the news media discussion of this question. I stand by that general assessment but have conceded that I have paid insufficient attention to the disparity in risk weights at the higher quality end of the mortgage risk spectrum.

A Discussion Paper released by APRA offers a useful discussion of this low risk weight question as part of a broader set of proposals intended to improve the transparency, flexibility and resilience of the Australian capital adequacy framework.

In section 4.2.1 of the paper, APRA notes the concern raised by standardised ADIs…

A specific concern raised by standardised ADIs in prior rounds of consultation has been the difference in capital requirements for lending at low LVRs. Stakeholders have noted that the lowest risk weight under the standardised approach would be 20 per cent under the proposed framework, but this appears to be significantly lower for the IRB approach. In response to this feedback, APRA has undertaken further analysis at a more detailed level, noting the difference in capital requirements that need to be taken into account when comparing capital outcomes under the standardised and IRB approaches (see Box 2 above).

But APRA’s assessment is that the difference is not material when you look beyond the simplistic comparison of risk weights and consider the overall difference in capital requirements

APRA does not consider that there is a material capital difference between the standardised and IRB approaches at the lower LVR level. For loans with an LVR less than 60 per cent, APRA has estimated that the pricing differential that could be reasonably attributed to differences in the capital requirements between the two approaches would be lower than the differential at the average portfolio outcome.

In explaining the reasons for this conclusion, APRA addresses some misconceptions about the IRB approach to low LVR lending compared to the standardised approach

In understanding the reasons for this outcome, it is important to understand the differences in how the standardised and IRB approaches operate. In particular, there are misconceptions around the capital requirement that would apply to low LVR lending under the IRB approach. For example, it would not be appropriate to solely equate the lowest risk weight reported by IRB ADIs in market disclosures with low LVR loans. The IRB approach considers a more complex range of variable interactions compared to the standardised approach. Under the standardised approach, a low risk weight is assigned to a loan with a low LVR at origination.

One of the key points APRA makes is that IRB ADIs do not get to originate loans at the ultra low risk weights that have been the focus of much of the concern raised by standardised ADIs.

In particular, IRB estimates are more dynamic through the life of the loan, for example, they are more responsive to a change in borrower circumstances or movements in the credit cycle. Standardised risk weights generally do not change over the life of a loan. For an IRB ADI, the lowest risk weight is generally applied to loans that have significantly prepaid ahead of schedule. A low LVR loan on the standardised approach is not necessarily assigned the lowest risk weight under the IRB approach at origination.

APRA states that it is not appropriate to introduce “dynamic”factors into the standardised risk weight framework.

APRA is not proposing to include dynamic factors in determining risk weights under the standardised approach for the following reasons:

– the standardised approach is intended to be simple and aligned with Basel III. For the standardised approach, APRA considers it more appropriate to focus on origination rather than behavioural variables as this has more influence on the quality of the portfolio and leads to less procyclical capital requirements; and

– the average difference between standardised and IRB capital outcomes is much narrower at the point of origination, which is the key point for competition. While the difference between standardised and IRB capital outcomes could widen over the life of the loan, APRA has ensured that the difference in average portfolio outcomes remains appropriate

But that it does intend to introduce a 5 per cent risk weight floor into the IRB approach to act as a backstop.

That said, APRA is proposing to implement a 5 per cent risk-weight floor for residential mortgage exposures under the IRB approach, to act as a simple backstop in ensuring capital outcomes do not widen at the lower risk segment of the portfolio. This is consistent with the approach taken by other jurisdictions and will limit the difference in capital outcomes between the standardised and IRB approaches for lower risk exposures. This risk-weight floor is in addition to other factors that will reduce the difference in capital outcomes between standardised and IRB ADIs, such as the higher CCB for IRB ADIs and lower CCF estimates for standardised ADIs.

As always, it remains possible that I am missing something. The explanation offered by APRA however gives me confidence that my broad argument about the overstatement of the difference has been broadly correct. Equally importantly, the changes to residential mortgage risk weights proposed in the Discussion Paper will further reduce the gap that does exist.

Tony – From the Outside

APRA reflects on “… a subtle but important shift in regulatory thinking”

Wayne Byres speech to the Risk Management Association covered a range of developments but, for me, the important part was the discussion of the distinction between strength and resilience referenced in the title of this post.

This extract from the speech sets out how Mr Byres frames the distinction …

… in the post-GFC period, the emphasis of the international reforms was on strengthening the global financial system. Now, the narrative is how to improve its resilience. A perusal of APRA speeches and announcements over time shows a much greater emphasis on resilience in more recent times as well.

What is behind this shift? Put simply, it is possible to be strong, but not resilient. Your car windscreen is a great example – without doubt it is a very strong piece of glass, but one small crack and it is irreparably damaged and ultimately needs to be replaced. That is obviously not the way we want the financial system to be. We want a system that is able to absorb shocks, even from so-called “black swan” events, and have the means to restore itself to full health.

In saying that, financially strong balance sheets undoubtedly help provide resilience, and safeguarding financial strength will certainly remain the cornerstone of prudential regulation and supervision. But it is not the full story. So with that in mind, let me offer some quick reflections on the past year, and what it has revealed about opportunities for the resilience of the financial system to be further improved.

APRA Chair Wayne Byres – Speech to the 2020 Forum of the Risk Management Association – 3 December 2020

To my mind, the introduction of an increased emphasis on resilience is absolutely the right way to go. We saw some indications of the direction APRA intend to pursue in the speech that Mr Byres gave to the AFR Banking and Wealth Summit last month and will get more detail next week (hopefully) when APRA releases a consultation paper setting out a package of bank capital reforms that is likely to include a redesign of the capital buffer framework.

This package of reforms is one to watch. To the extent that it delivers on the promise of increasing the resilience of the Australian banking system, it is potentially as significant as the introduction of the “unquestionably strong” benchmark in response to the Australian Financial System Inquiry.

Tony – From the Outside

Bank capital adequacy – APRA chooses Option 2

APRA released a discussion paper in August 2018 titled “Improving the transparency, comparability and flexibility of the ADI capital framework” which offered two alternative paths.

  • One (“Consistent Disclosure”) under which the status quo would be largely preserved but where APRA would get involved in the comparability process by adding its imprimatur to the “international harmonised ratios” that the large ADIs use to make the case for their strength compared to their international peers, and
  • A second (“Capital Ratio Adjustments”) under which APRA would align its formal capital adequacy measure more closely with the internationally harmonised approach.

I covered those proposals in some detail here and came out in favour of the second option. I don’t imagine APRA pay much attention to my blog but in a speech delivered to the AFR Banking and Wealth Summit Wayne Byres flagged that APRA do in fact intend to pursue the second option.

The speech does not get into too much detail but it listed the following features the proposed new capital regime will exhibit:

– more risk-based – by adjusting risk weights in a range of areas, some up (e.g. for higher risk housing) and some down (e.g. for small business);
 – more flexible – by changing the mix between minimum requirement and buffers, utilising more of the latter;
 – more transparent – by better aligning with international minimum standards, and making the underlying strength of the Australian framework more visible;
 – more comparable – by, in particular, making sure all banks disclose a capital ratio under the common, standardised approach; and
 – more proportionate – by providing a simpler framework suitable for small banks with simple business models.

while also making clear that

… probably the most fundamental change flowing from the proposals is that bank capital adequacy ratios will change. Specifically, they will tend to be higher. That is because the changes we are proposing will, in aggregate, reduce risk-weighted assets for the banking system. Given the amount of capital banks have will be unchanged, lower risk-weighted assets will produce higher capital ratios.

However, that does not mean banks will be able to hold less capital overall. I noted earlier that a key objective is to not increase capital requirements beyond the amount needed to meet the ‘unquestionably strong’ benchmarks. Nor is it our intention to reduce that amount. The balance will be maintained by requiring banks to hold larger buffers over their minimum requirements.

One observation at this stage …

It is hard to say too much at this stage given the level of detail released but I do want to make one observation. Wayne Byres listed four reasons for the changes proposed;

  1. To improve risk sensitivity
  2. To make the framework more flexible, especially in times of stress
  3. To make clearer the fundamental strength of our banking system vis-a-vis international peers
  4. To ensure that the unquestionably strong capital built up prior to the pandemic remains a lasting feature of the Australian banking system.

Pro-cyclicality remains an issue

With respect to increasing flexibility, Wayne Byres went on to state that “Holding a larger proportion of capital requirements in the form of capital buffers main that there is more buffer available to be utilised in times of crisis” (emphasis added).

It is true that the capital buffer will be larger in basis points terms by virtue of the RWA (denominator in the capital ratio) being reduced. However, it is also likely that the capital ratio will be much more sensitive to the impacts of a stress/crisis event.

This is mostly simple math.

  1. I assume that loan losses eating into capital are unchanged.
  2. It is less clear what happens to capital deductions (such as the CET1 deduction for Regulatory Expected Loss) but it is not obvious that they will be reduced.
  3. Risk Weights we are told will be lower and more risk sensitive.
  4. The lower starting value for RWA in any adverse scenario means that the losses (we assume unchanged) will translate into a larger decline in the capital ratio for any given level of stress.
  5. There is also the potential for the decline in capital ratios under stress to be accentuated (or amplified) to the extent the average risk weights increase in percentage terms more than they would under the current regime.

None of this is intended to suggest that APRA has made the wrong choice but I do believe that the statement that “more buffer” will be available is open to question. The glass is however most definitely half full. I am mostly flagging the fact that pro-cyclicality is a feature of any risk sensitive capital adequacy measure and I am unclear on whether the proposed regime will do anything to address this.

The direction that APRA has indicated it intends to take is the right one (I believe) but I think there is an opportunity to also address the problem of pro-cyclicality. I remain hopeful that the consultation paper to be released in a few weeks will shed more light on these issues.

Tony – From the Outside

p.s. the following posts on my blog touch on some of the issues that may need to be covered in the consultation

  1. The case for lower risk weights
  2. A non zero default for the counter cyclical capital buffer
  3. The interplay of proposed revisions to APS 111 and the RBNZ requirement that banks in NZ hold more CET1 capital
  4. Does expected loss loan provisioning reduce pro-cyclicality
  5. My thoughts on a cyclical capital buffer

Corporate social responsibility – going back to the source

The 50th anniversary of Milton Friedman’s 1970 essay has triggered a deluge of commentary celebrating or critiquing the ideas it proposed. My bias probably swings to the “profit maximisation is not the entire answer” side of the debate but I recognised that I had not actually read the original essay. Time, I thought, to go back to the source and see what Friedman actually said.

I personally found this exercise useful because I realised that some of the commentary I had been reading was quoting him out of context or otherwise reading into his essay ideas that I am not sure he would have endorsed. I will leave my comment on the merits of his doctrine to another post.

Friedman’s doctrine of the limits of corporate social responsibility

Friedman’s famous (or infamous) conclusion is that in a “free” society…

there is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception fraud.”

My more detailed notes on what Friedman wrote can be found here. That note includes lengthy extracts from the essay so that you can fact check my paraphrasing of what he said. My summary of his argument as I understand it runs as follows:

  • Friedman first seeks to establish that any meaningful discussion of social responsibility has to focus on the people who own or manage the business, not “the business” itself.
  • If we focus on the corporate executives who manage the business as agents of the shareholders, Friedman argues that these executive should only use the resources of a company to pursue the objectives set by their “employer” (i.e. the shareholders).
  • What do the shareholders want the business to do?
  • Friedman acknowledges that some may have different objectives but he assumes that profit maximisation constrained by the laws and ethical customs of the society in which they operate will be goal of most shareholders
  • The key point however is that corporate executives have no authority or right to pursue any objectives other than those defined by their employer (the shareholders) or which otherwise serve the interests of those people.
  • Friedman also argues that the expansion of social responsibilities introduces conflicts of interest into the management of the business without offering any guide or proper process for resolving them. Having multiple (possibly ill defined and conflicting) objectives is, Friedman argues, a recipe for giving executives an excuse to underperform.
  • Friedman acknowledges that corporate executives have the right to pursue whatever social responsibilities they choose in their private lives but, as corporate executives, their personal objectives must be subordinated to the responsibility to achieve the objectives of the shareholders, their ultimate employers.
  • It is important to understand how Friedman defined the idea of a corporate executive having a “social responsibility”. He argues that the concept is only meaningful if it creates a responsibility that is not consistent with the interests of their employer.
  • Friedman might be sceptical on the extent to which it is true, but my read of his essay is that he is not disputing the rights of a business to contribute to social and environmental goals that management believe are congruent with the long term profitability of the business.
  • Friedman argues that the use of company resources to pursue a social responsibility raises problematic political questions on two levels: principle and consequences.
  • On the level of POLITICAL PRINCIPLE, Friedman uses the rhetorical device of treating the exercise of social responsibility by a corporate executive as equivalent to the imposition of a tax
  • But it is intolerable for Friedman that this political power can be exercised by a corporate executive without the checks and balances that apply to government and government officials dealing with these fundamentally political choices.
  • On the grounds of CONSEQUENCES, Friedman questions whether the corporate executives have the knowledge and expertise to discharge the “social responsibilities” they have assumed on behalf of society. Poor consequences are acceptable if the executive is spending their own time and money but unacceptable as a point of principle when using someone else’s time and money.
  • Friedman cites a list of social challenges that he argues are likely to lay outside the domain of a corporate executive’s area of expertise
  • Private competitive enterprise is for Friedman the best way to make choices about how to allocate resources in society. This is because it forces people to be responsible for their own actions and makes it difficult for them to exploit other people for either selfish or unselfish purposes.
  • Friedman considers whether some social problems are too urgent to be left to the political process but dismisses this argument on two counts. Firstly because he is suspicious about how genuine the commitment to “social responsibility” really is but mostly because he is fundamentally committed to the principle that these kinds of social questions should be decided by the political process.
  • Friedman acknowledges that his doctrine makes it harder for good people to do good but that, he argues, is a “small price” to pay to avoid the greater evil of being forced to conform to an objective you as an individual do not agree with.
  • Friedman also considers the idea that shareholders can themselves choose to contribute to social causes but dismisses it. This is partly because he believes that these “choices” are forced on the majority by the shareholder activists but also because he believes that using the “cloak of social responsibility” to rationalise these choices undermines the foundations of a free society.
  • That is a big statement – how does he justify it?
  • He starts by citing a list of ways in which socially responsible actions can be argued (or rationalised) to be in the long-run interests of a corporation.
  • Friedman acknowledges that corporate executives are well within their rights to take “socially responsible” actions if they believe that their company can benefit from this “hypocritical window dressing”.
  • Friedman notes the irony of expecting business to exercise social responsibility by foregoing these short term benefits but argues that using the “cloak of social responsibility” in this way harms the foundations of a free society
  • Friedman cites the calls for wage and price controls (remember this was written in 1970) as one example of the way in which social responsibility can undermine a free society
  • But he also sees the trend for corporate executives to embrace social responsibility as part of a wider movement that paints the pursuit of profit as “wicked and immoral”. A free enterprise, market based, society is central to Friedman’s vision of a politically free society and must be defended to the fullest extent possible.
  • Here Friedman expands on the principles behind his commitment to the market mechanism as an instrument of freedom – in particular the principle of “unanimity” under which the market coordinates the needs and wants of individuals and no one is compelled to do something against their perceived interests.
  • He contrasts this with the principle of “conformity” that underpins the political mechanism.
  • In Friedman’s ideal world, all decisions would be based on the principle of unanimity but he acknowledges that this is not always possible.
  • He argues that the line needs to be drawn when the doctrine of “social responsibility” extends the political mechanisms of conformity and coercion into areas which can be addressed by the market mechanism.
Friedman concludes by labelling “social responsibility” a “fundamentally subversive doctrine”.

But the doctrine of “social responsibility” taken seriously would extend the scope of the political mechanism to every human activity. It does not differ in philosophy from the most explicitly collectivist doctrine. It differs only by professing to believe that collectivist ends can be attained without collectivist means.

That is why, in my book “Capitalism and Freedom,” I have called it a “fundamentally subversive doctrine” in a free society, and have said that in such a society, “there is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception fraud.”

Hopefully what I have set out above offers a fair and unbiased account of what Friedman actually said. If not then tell me what I missed. I think he makes a number of good points but, as stated at the beginning of this post, I am not comfortable with the conclusions that he draws. I am working on a follow up post where I will attempt to deconstruct the essay and set out my perspective on the questions he sought to address.

Tony – From the Outside

Martin Wolf discussing the history of how we got to here

podcasts.apple.com/au/podcast/economics-beyond-with-rob-johnson/id1509092730

This interview with Rob Johnson (Institute for New Economic Thinking) does not contain any revelations but it does offer a good history of the politics of how the financial system was deregulated.

Tony – From the Outside