Financialisation and Maximizing Shareholder Value

It is perhaps no longer surprising or shocking that terms and concepts or even simple words are articulated differently by many. Consider for instance ‘financialisation’, a term that acquired currency in the wake of the growing market for all kinds of derivatives. The global business media understood this, correctly in my opinion, as the drive towards rendering everything in terms of finance. However, we must be precise: financialisation can only be understood as the drive to create a tradeable security out of anything. The origin really doesn’t matter as long as it lends itself to creating a security that can be traded in the financial markets. It needs no emphasis that it is in the US money and financial markets that we have seen this trend deepening. In some sense, this acquired a frenetic momentum in the events leading to the 2008 financial markets crisis, which arose out of this obsession but with specific reference to the housing market in the mortgage-back securities.

The point is that, given the basic premise of a derivative, any underlying can be used to create a derivative instrument, be it receivables from mortgage payments, rent receivables or whatever. Readers may recall that, in the case of the MBS, the need was to create the original loan without which there would be no receivables and hence no derivative instrument. Some may recall further that this was called the origination scandal, when American citizens not really capable of buying houses managed to do so through what has now become an immortal expression – sub-prime. There is a certain irony here. The borrowers under this category were sub-prime but they became the prime foundation of an entire, very fragile as it turned out, foundation of a specific class of derivative instruments.        

In most of the discussions around the meltdown, one dimension just escaped everyone’s attention – the desperate search for assets into which monies could be invested to yield an attractive return. The increasing independence of financial markets, especially derivatives, was a function of investible funds looking for parking places. There is something deeper at play here – circulation of money lost its links with the real economy and became an insular world as long as asset prices stayed high. This is a singular lacuna in most discussions of macro-economics. While it became crystal clear in the 2008 crisis, the entire MBS syndrome was a punt on housing prices, this is true of all derivatives – they are a punt on the prices of underlying assets.

Many non-finance academicians and especially those claiming allegiance to Marx have been using the term financialisation as equivalent to the deepening of the profit motive, especially corporate (and the corporatization of what were once state-owned entities) together with, in countries such as India, the displacement of socialistic criteria. Many Marxist especially condemn the corporate pursuit of quarterly profit to the neglect of almost everything else. This is unfortunate as it completely misses the point about financialisation: its umbilical cord is with financial markets.

What such writers have confused financialisation with is ‘shareholder-value maximisation’, a principle that originated seriously in the USA (no surprises there) but now informs almost every corporate sector. According to the principle, followed quite fiercely by Indian companies, public capital-raising firms exist to ensure that shareholder wealth is maximized, which simply means that the share price is maximized, given a time horizon. Shareholder model of capitalism has been around for quite some time and is foraying into territories such as Europe (which mothered the stakeholder model of capitalism after the Second World War). But, it is not the same as financialisation.

There is an interesting connection though. In 1973, option pricing is given a ‘scientific status’ through Black-Scholes. Although no one realized it then, at least not completely, it created not just a new asset class but founded the possibility of creating multiple assets within the broad class of derivatives as an asset class. It was simply a matter of time before swaption, option on futures and so on. All that was needed was an underlying, any underlying – the distinguishing characteristic of derivatives. You can just imagine the sense of freedom that traders and investment managers must have felt when this possibility asserted itself deeper and deeper to cover almost anything. Everyone got into the picture, even those who had no connection to the market. For example, people who had no foreign exchange to pay or receive became active in the forex markets. In fact, around the mid-80s, the volume of forex traded ceased to have any relation to the volume of international trade, which means most of the players were simply speculators. Much the same happened in the derivatives market. Markets, as any finance student knows, is all about volumes and volumes are not possible without speculators.

More important, this became an additional source of income for companies and thus contributed to shareholder value. The rise of ‘finance income’ as a share of corporate profits has been much commented upon. Of course, it did fluctuate because it can be volatile but it played its part and continues to do in the orchestrated play of shareholder value maximization. Thus, financialisation and shareholder value maximization have gone together since the discovery of options, but are not the same.

Some writer said that “if there were no God, we would have to invent Him”. In financialisation, we have to invent the underlying so that we can create a derivative. The cycle will never stop.