I have been referencing Matt Levine a lot lately. No apologies, his Money Stuff column is a regular source of insight and entertainment for banking and finance tragics such as myself and I recommend it. His latest column (behind a paywall but you can access a limited number of articles for free I think) includes a discussion of the way in which the DeFi industry has created analogues of conventional banking concepts like “deposits” but with twists that are not always obvious or indeed intuitive to the user/customer.
We have talked a lot recently about how crypto has recreated the pre-2008 financial system, and is now having its own 2008 financial crisis. But this is an important difference. Traditional finance is in large part in the business of creating safe assets: You take stuff with some risk (mortgages, bank loans, whatever), you package them in a diversified and tranched way, you issue senior claims against them, and people treat those claims as so safe that they don’t have to worry about them. Money in a bank account simply is money; you don’t have to analyze your bank’s financial statements before opening a checking account.
Matt Levine “Money Stuff” column 28 June 2022 – Crypto depositors
How banks can create safe assets is a topic that I have looked at a number of times but this post is my most complete attempt to describe the process that Matt outlines above. To me at least, this is a pretty fundamental part of understanding how finance works and Matt also did a good post on the topic that I discussed here.
One of the key points is that the tranching of liabilities also creates a division of labour (and indeed of expertise and inclination) …
There is a sort of division of labor here: Ordinary people can put their money into safe places without thinking too hard about it; smart careful investors can buy equity claims on banks or other financial institutions to try to make a profit. But the careless ordinary people have priority over the smart careful people. The smart careful heavily involved people don’t get paid unless the careless ordinary people get paid first. This is a matter of law and banking regulation and the structuring of traditional finance. There are, of course, various possible problems; in 2008 it turned out that some of this information-insensitive debt was built on bad foundations and wasn’t safe. But the basic mechanics of seniority mostly work pretty well.
The DeFi industry argues that they want to change the ways that traditional finance operates for the benefit of users but it also expects those users to be motivated and engaged in understanding the details of the new way of doing things. A problem is that some users (maybe “many users”?) might be assuming that some of the rules that protect depositors (and indeed creditors more generally) in the conventional financial system would naturally be replicated in the alternative financial system being created.
Back to Matt …
The reason people put their money in actual banks is that we live in a society and there are rules that protect bank deposits, and also everyone is so used to this society and those rules that they don’t think about them. Most bank depositors do not know much about bank capital and liquidity requirements, because they don’t have to; that is the point of those requirements.
The problem according to Matt is ….
Broadly speaking crypto banking (and quasi-banking) is like banking in the state of nature, with no clear rules about seniority and depositor protection. But it attracts money because people are used to regular banking. When they see a thing that looks like a bank deposit, but for crypto, they think it will work like a bank deposit. It doesn’t always.
This feels like a problem to me. As the industry becomes more regulated I would expect to see the issues of seniority and deposit protection/preference more clearly spelled out. For the time being it does seem to be very much caveat emptor and don’t assume anything.
Anyone moderately familiar with crypto assets is no doubt aware that the Terra stablecoin has been experiencing problems with its algorithmic smart contract controlled peg mechanism. There are lots of lessons here I am but I think Matt Levine flags one of the more interesting ones in his “Money Stuff” column (13 May 2022).
Safe assets are much riskier than risky ones.
Matt goes on to expand on why this is so …
This is I think the deep lesson of the 2008 financial crisis, and crypto loves re-learning the lessons of traditional finance. Systemic risks live in safe assets. Equity-like assets — tech stocks, Luna, Bitcoin — are risky, and everyone knows they’re risky, and everyone accepts the risk. If your stocks or Bitcoin go down by 20% you are sad, but you are not that surprised. And so most people arrange their lives in such a way that, if their stocks or Bitcoin go down by 20%, they are not ruined.
On the other hand safe assets — AAA mortgage securities, bank deposits, stablecoins — are not supposed to be risky, and people rely on them being worth what they say they’re worth, and when people lose even a little bit of confidence in them they crack completely. Bitcoin is valuable at $50,000 and somewhat less valuable at $40,000. A stablecoin is valuable at $1.00 and worthless at $0.98. If it hits $0.98 it might as well go to zero. And now it might!
The takeaway for me is to once again highlight the way in which supposedly safe, “no questions need be asked”, assets can sometimes be worse than assets we know are risky due to the potential for them to quickly flip into something for which there is no liquidity, just a path to increasingly large price falls. This is a theme that I regularly hammer (so apologies if you are tired of it) but still for me one of the more important principles in finance (right up there with “no free lunch”).
One of the arguments for buying Bitcoin is that, in contrast to fiat currencies that are at mercy of the Central Bank money printer, its value is underpinned by the fixed and immutable supply of coins built into the code. Some cryptocurrencies take this a step further by engineering a systematic burning of their coin.
I worry about inflation as much as the next person, perhaps more so since I am old enough to have actually lived in an inflationary time. I think a fixed or shrinking supply is great for an asset class but it is less obvious that it is a desirable feature of a money system.
Crypto true believers have probably stopped reading at this point but to understand why a fixed supply might be problematic I can recommend a short speech by Claudio Borio. The speech dates back to 2018 but I think it continues to offer a useful perspective on the value of an elastic money supply alongside broader comments about the nature of money and its role in the economy.
Borio was at the time the Head of the BIS Monetary and Economic Department but the views expressed were his personal perspective covering points that he believed to be well known and generally accepted, alongside others more speculative and controversial.
I did a post back in March 2019 that offers an overview of the speech but recently encountered a post by J.W. Mason which reminded me how useful and insightful it was.
The specific insight I want to focus on here is the extent to which a well functioning monetary system relies on the capacity of credit extended in the system to expand and contract in response to both short term settlement demands and the longer term demands driven by economic growth.
One of the major challenges with the insight Borio offers is that most of us find the idea that money is really just a highly developed form of debt to be deeply unsatisfying if not outright scary. Borio explicitly highlights “the risk of overestimating the distinction between credit (debt) and money” arguing that “…we can think of money as an especially trustworthy type of debt”
Put differently, we can think of money as an especially trustworthy type of debt. In the case of bank deposits, trust is supported by central bank liquidity, including as lender of last resort, by the regulatory and supervisory framework and varieties of deposit insurance; in that of central bank reserves and cash, by the sovereign’s power to tax; and in both cases, by legal arrangements, way beyond legal tender laws, and enshrined in market practice.
Borio: Page 9
I did a post here that explains in more detail an Australian perspective on the process by which unsecured loans to highly leveraged companies (aka “bank deposits”) are transformed into (mostly) risk free assets that represent the bulk of what we use as money.
Borio outlines how the central banks’ elastic supply of the means of payment is essential to ensure that (i) transactions are settled in the interbank market and (ii) the interest rate is controlled …
“To smooth out interbank settlement, the provision of central bank credit is key. The need for an elastic supply to settle transactions is most visible in the huge amounts of intraday credit central banks supply to support real-time gross settlement systems – a key way of managing risks in those systems (Borio (1995)).”
Borio: Page 5
… but also recognises the problem with too much elasticity
While the elasticity of money creation oils the wheels of the payment system on a day to day basis, it can be problematic over long run scenarios where too much elasticity can lead to financial instability. Some degree of elasticity is important to keep the wheels of the economy turning but too much can be a problem because the marginal credit growth starts to be used for less productive or outright speculative investment.
This is a big topic which means there is a risk that I am missing something. That said, the value of an elastic supply of credit looks to me like a key insight to understanding how a well functioning monetary system should be designed.
The speech covers a lot more ground than this and is well worth reading together with the post by J.W. Mason I referenced above which steps through the insights. Don’t just take my word for it, Mason introduces his assessment with the statement that he was “…not sure when I last saw such a high density of insight-per-word in a discussion of money and finance, let alone in a speech by a central banker”.
Shout out to Tim Harford for this introduction to the study of how, in his words, ignorance can be deliberately produced. The technical term “agnatology” is I suspect unlikely to catch on but the underlying message is one worth understanding. At a minimum it is a handy addition to your Scrabble dictionary.
The article was originally published in March 2017 but I only came across it recently via this podcast interview Harford did with Cardiff Garcia on “The New Bazaar”. The context in 2017 was the successful campaign for the US presidency that Donald Trump ran during 2016 with a bit of Brexit thrown in but this is a challenge that is not going away anytime soon.
Harford notes that it is tempting to think that the answer to the challenge posed by what has come to be known as a post truth society lies in a better process to establish the facts
The instinctive reaction from those of us who still care about the truth — journalists, academics and many ordinary citizens — has been to double down on the facts.
He affirms the need to have some agreement on how we distinguish facts from opinions and assertions but he cautions that this is unlikely to solve the problem. He cites the tobacco industry response to the early evidence that smoking causes cancer to illustrate why facts alone are not enough.
A good place to start is by delving into why facts alone are not enough – a few extracts from the article hopefully capture the main lessons
Doubt is usually not hard to produce, and facts alone aren’t enough to dispel it. We should have learnt this lesson already; now we’re going to have to learn it all over again…
Tempting as it is to fight lies with facts, there are three problems with that strategy…
The first is that a simple untruth can beat off a complicated set of facts simply by being easier to understand and remember. When doubt prevails, people will often end up believing whatever sticks in the mind…
There’s a second reason why facts don’t seem to have the traction that one might hope. Facts can be boring. The world is full of things to pay attention to, from reality TV to your argumentative children, from a friend’s Instagram to a tax bill. Why bother with anything so tedious as facts?…
In the war of ideas, boredom and distraction are powerful weapons. The endgame of these distractions is that matters of vital importance become too boring to bother reporting…
There’s a final problem with trying to persuade people by giving them facts: the truth can feel threatening, and threatening people tends to backfire. “People respond in the opposite direction,” says Jason Reifler, a political scientist at Exeter University. This “backfire effect” is now the focus of several researchers, including Reifler and his colleague Brendan Nyhan of Dartmouth…
The problem here is that while we like to think of ourselves as rational beings, our rationality didn’t just evolve to solve practical problems, such as building an elephant trap, but to navigate social situations. We need to keep others on our side. Practical reasoning is often less about figuring out what’s true, and more about staying in the right tribe…
We see what we want to see — and we reject the facts that threaten our sense of who we are…
When we reach the conclusion that we want to reach, we’re engaging in “motivated reasoning”…
Even in a debate polluted by motivated reasoning, one might expect that facts will help. Not necessarily: when we hear facts that challenge us, we selectively amplify what suits us, ignore what does not, and reinterpret whatever we can. More facts mean more grist to the motivated reasoning mill. The French dramatist Molière once wrote: “A learned fool is more foolish than an ignorant one.” Modern social science agrees…
When people are seeking the truth, facts help. But when people are selectively reasoning about their political identity, the facts can backfire.
So what are we to do?
Harford cites a study that explores the value of scientific curiosity
What Kahan and his colleagues found, to their surprise, was that while politically motivated reasoning trumps scientific knowledge, “politically motivated reasoning . . . appears to be negated by science curiosity”. Scientifically literate people, remember, were more likely to be polarised in their answers to politically charged scientific questions. But scientifically curious people were not. Curiosity brought people together in a way that mere facts did not. The researchers muse that curious people have an extra reason to seek out the facts: “To experience the pleasure of contemplating surprising insights into how the world works.”
It is of course entirely possible that Tim Harford’s assessment is just calling to my own bias. I will admit that one the things that I always looked for when hiring, or working, with people was curiosity. These people are surprisingly rare but (IMHO) worth their weight in gold. An intellectually curious mind makes up for a lot of other areas where the person might not be perfect in terms of skills or experience. The general point (I think) also ties to the often cited problem that people with lots of knowledge can sometimes be prone to not being so street smart. Nassim Taleb makes this argument in nearly everything he writes.
So Tim Harford might not be offering the entire answer but I think his article is worth reading on two counts
Firstly as a cautionary tale against expecting that all debates and disputes can be resolved by simply establishing the “facts”
Secondly as a reminder of the power of a curious mind and the value of the never-ending search for “what am I missing?”
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).
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.
I have been digging into the debate about what Milton Friedman got right and wrong about the social responsibility of business. I am still in the process of organising my thoughts but this discussion on the “Capitalisn’t” podcast is, I think, worth listening to for anyone interested in the questions that Friedman’s 1970 essay raises.
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.
Anyone with more than a casual interest in business will be familiar with the increased focus on Environmental, Social and Governance (ESG) issues. There are sound arguments being made on both sides of the debate but I will admit upfront that I approach the topic with a somewhat ESG positive bias. Given my bias, it is all the more important to pay attention to what the sceptics are calling out rather than looking for affirmation amongst the true believers.
A post by Aswath Damodaran titled “Sounding good or Doing good? A Skeptical Look at ESG” is one of the better contributions to the ESG debate that I have encountered. I discussed one of his earlier contributions to the debate here and it is clear that he is not a fan of ESG. I am still working through his arguments but I like the analytical framework he employs and the way in which he supports his arguments with evidence.
I intend to do a couple of posts digging down into the ESG debate using Damodaran’s post and few other sources but want to start by laying out his arguments with some very limited comments.
Damodaran starts by framing ESG as part of a tradition of business ideas that have tended to prove to be more noise than substance, describing the ESG “sales pitch” as follows
“Companies that improve their social goodness standing will not only become more profitable and valuable over time, we are told, but they will also advance society’s best interests, thus resolving one of the fundamental conflicts of private enterprise, while also enriching investors”
There is no doubt that ESG, like many other business ideas, is prone to being over-hyped. There is room to take issue with the question of whether this is a fair description of the ESG movement as a whole. My gut feel is that presenting the “sales pitch” version is not representative of ESG advocates who genuinely believe that ESG can address problems in the ways the market currently operate, but it will be more productive to focus on the specific weaknesses that Damodaran discusses.
Damodaran starts with the problem of measurement
“Any attempts to measure environment and social goodness face two challenges.
– The first is that much of social impact is qualitative, and developing a numerical value for that impact is difficult to do.
– The second is even trickier, which is that there is little consensus on what social impacts to measure, and the weights to assign to them.”
Assuming the measurement issues can be resolved, the second problem is identifying exactly how incorporating ESG factors into the business model or strategy contributes to improving the value of a company. Damodaran uses the following generic model of value drivers to explore this question
Figure 1: The Drivers of Value
Using this framework, Damodaran identifies two ways in which a company can derive benefits from incorporating ESG principles into its business strategy
Goodness is rewarded – i.e. companies behave in a socially responsible way because it creates positive outcomes for their business
Badness is punished – i.e. companies behave in a socially responsible way because bad behaviour is punished
Damodaran also identifies a third scenario in which “The bad guys win”
“In this scenario, bad companies mouth platitudes about social responsibility and environmental consciousness without taking any real action, but customers buy their products and services, either because they are cheaper or because of convenience, employees continue to work for them because they can earn more at these companies or have no options, and investors buy their shares because they deliver higher profits. As a result, bad companies may score low on corporate responsibility scales, but they will score high on profitability and stock price performance.”
Damodaran argues that the evidence supports the following conclusions:
A weak link to profitability
“There are meta studies (summaries of all other studies) that summarize hundreds of ESG research papers, and find a small positive link between ESG and profitability, but one that is very sensitive to how profits are measured and over what period, leading one of these studies to conclude that “citizens looking for solutions from any quarter to cure society’s pressing ills ought not appeal to financial returns alone to mobilize corporate involvement”. Breaking down ESG into its component parts, some studies find that environment (E) offered the strongest positive link to performance and social (S) the weakest, with governance (G) falling in the middle.”
2) A stronger link to funding costs
“Studies of “sin” stocks, i.e., companies involved in businesses such as producing alcohol, tobacco, and gaming, find that these stocks are less commonly held by institutions, and that they face higher costs for funding, from equity and debt). The evidence for this is strongest in sectors like tobacco (starting in the 1990s) and fossil fuels (especially in the last decade), but these findings come with a troubling catch. While these companies face higher costs, and have lower value, investors in these companies will generate higher returns from holding these stocks.”
3) Some evidence that ESG focussed companies do reduce their risk of failure or exposure to disaster risk
“An alternate reason why companies would want to be “good” is that “bad” companies are exposed to disaster risks, where a combination of missteps by the company, luck, and a failure to build in enough protective controls (because they cost too much) can cause a disaster, either in human or financial terms. That disaster can not only cause substantial losses for the company, but the collateral reputation damage created can have long term consequences. One study created a value-weighted portfolio of controversial firms that had a history of violating ESG rules, and reported negative excess returns of 3.5% on this portfolio, even after controlling for risk, industry, and company characteristics. The conclusion in this study was that these lower excess returns are evidence that being socially irresponsible is costly for firms, and that markets do not fully incorporate the consequences of bad corporate behavior. The push back from skeptics is that not all firms that behave badly get embroiled in controversy, and it is possible that looking at just firms that are controversial creates a selection bias that explains the negative returns.”
Damodaran sums up his argument
“There is a weak link between ESG and operating performance (growth and profitability), and while some firms benefit from being good, many do not. Telling firms that being socially responsible will deliver higher growth, profits and value is false advertising. The evidence is stronger that bad firms get punished, either with higher funding costs or with a greater incidence of disasters and shocks. ESG advocates are on much stronger ground telling companies not to be bad, than telling companies to be good. In short, expensive gestures by publicly traded companies to make themselves look “good” are futile, both in terms of improving performance and delivering returns.”
There is a lot more to say on this topic. The evidence that certain types of companies do get punished for failing to be socially responsible is especially interesting. I see a fair degree of cynicism applied to the ESG stance adopted by the Australia banks but I suspect they are a good example of the type of company that will in fact benefit from making real investments in socially responsible business strategies.