Economists and students of management have for long grappled with what they call the agency problem, or how to ensure that the incentives for managers, or agents, is more closely aligned to the interests of shareholders. Give managers too much say in a business and they are apt to vote big bonuses for themselves and build empires. Give shareholders too much control and they may interfere in business decisions best left to professional managers. Randall Morck and Fan Yang have documented an extensive banking system that existed in the 19th century in China’s remote Shanxi province that, rather incredibly, solved this vexed problem.
Even more amazing was the fact that Shanxi, a remote northern inland province, emerged as China’s pre-eminent banking centre in the 19th century. The authors argue that Western influences may have been the catalyst, as Shanxi merchants ran a lucrative trade in tea across the Gobi desert into Russia right up to St. Petersburg. Exposure to the banking practices in the Russian capital may have helped the Shanxi bankers. Whatever may be the reason, the Shanxi bankers grew rapidly by providing bank drafts to merchants. During the colonial wars and uprisings of the 19th century, they expanded their services to the government, with one much-impressed emperor calling Shanxi’s Sunrise Provident Bank the “Clearance Everywhere Under Heaven Bank”.
The banks’ management and corporate governance systems may have been a reason for their success. First, they were professionally managed. In their study of the Sunrise Provident Bank, the authors found two classes of shares—one for managers and the other for shareholders. The former were given a large number of non-voting shares, called expertise shares. The latter’s shares were called capital shares. The study says: “To discourage entrenchment, managers’ shares carried non-binding votes in management meetings only; while owners’ shares carried votes only on Grand Assessment Days held after each fiscal cycle (typically three or four years) to fire or retain managers and reallocate their shares. This precisely inverts modern dual class structures, which grant insiders overwhelming voting control. To further align managers’ and owners’ interests, both classes paid identical dividends.” So while the professional managers ran the bank, it was the shareholders who decided whether they were doing a good job and they could fire the managers if they weren’t. Moreover, this was done, not on the basis of quarterly results, but at intervals of three-four years, which allowed managers to take a long-term view of the bank’s interests. Expertise shareholders could influence the day to day operation of the firm, each having a voice proportional to his expertise shareholdings. This voice bestowed the right to make and vote on suggestions to the general manager, who might act on them or not. Final control over all business decisions was entirely in the hands of the general manager. This long-term focus was buttressed by another practice—that of granting another class of shares called dead shares to retired managers or to the families of managers who had died in service. These shares existed for a specified period that was written into the employment contract of the manager. They had no voting rights, not even in management meetings, but were entitled to dividends.
And finally, as an insurance against fraud, contracts permitted the enslavement of managers’ wives and children, a practice that many shareholders in the big Western banks hit by the crisis would doubtless welcome.
So why did this paragon of corporate governance collapse? A powerful owner changed the rules, assigned expertise shares in addition to his capital shares and interfered in lending decisions. It was downhill all the way after that. We have a lot to learn from the governance structures of the Shanxi banks.
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