Introducing Social Contract Accounting Part One

This is the first of a two-part article (part two) designed to introduce the concept of Social Contract Accounting. It aims to describe in brief terms the background and context to the concept. The second part will expand upon it. This part draws heavily upon two speeches by Andy Haldane, Chief Economist at the Bank of England, with supplements and summaries that are my own opinions. I am grateful to Andy for making complex issues clear, concise and comprehensible. He made my job much easier.

Let me begin by stating that in my view, driven by the ideology of neoliberal economists, we find ourselves in a situation where ‘the tail is wagging the dog’. Rather than finance and the economy serving society by creating prosperity, many groups in society have suffered in order to maintain a ‘healthy’ economy. And financialisaton means money is used to create more money, rather than being put to productive use. In other words, the ‘means’ have become the ‘end’.

In a Speech in October 2012 Andy talked of the need for “socially responsible banking”, following the “Heineken era, in which credit reached the parts of society it previously had not reached”, beginning in the 1990’s. Followed by the manufacture of new financial products by banks, which involved “slicing and dicing loans to meet investor demand for high yield”. These “high-tech loans” meant “returns to banking rose to their highest levels since the roaring ‘20's”. And, “with returns sky-high, there was then a great sucking sound as both people and monies were drawn into banking”.

“Funds flowed into the bank money-machine, with balance sheets rising fivefold in less than 20 years, much of it to support short-term trading activities rather than long-term investment”. And, in the process, “many of the best people and the best financial resources were drawn away from other sectors”. With "the sectors hardest-hit by this financial vacuum-cleaner effect are R&D-intensive businesses”, the most productive parts of the real economy, the creators of prosperity.

In 2015 the Bank of England launched an Open Forum initiative, acknowledging “financial markets can and should be powerful drivers of prosperity. But markets can go wrong”. Research had been done for the event. It focused on perceptions of the financial sector and found the word most used by the public when describing financial markets “was “corrupt”. Not far behind were words like “manipulated”, “self-serving”, “destructive” and “greedy””.

The findings highlighted a great divide “between the perceptions of producers and consumers of financial services, between the silent majority who buy and the vocal minority who sell financial products”, as Andy put it in a later speech. In that speech he went on to talk about, “the crucial role finance plays in society and why”, and “the progress made, so far, in restoring trust in finance”. More importantly he addressed, “what further progress might be needed to narrow that trust deficit, and suggested, “that may call for the financial sector to seek new ways to define and communicate its purpose, its contribution to wider society, to act as an antidote to the short-term demands of shareholders and executives”.

Andy cautioned, “It is not just bankers who have suffered a loss of public trust. In varying degrees, this is also true of big business, government and, yes, politicians and central banks”. Then he said, a “well-functioning financial sector is an essential foundation for a growing and well-functioning economy”, and noted, “over long periods of time and across wide ranges of countries, well-functioning finance has supported wealth-creation and well-being”.

He went on to suggest, the importance of the sector can be best understood when things go wrong and, “the collapse of capital during financial crises shows up, most obviously and immediately, in measures of financial capital”. “Yet it is another form of capital that may matter every bit as much to wealth and well-being in society – social capital” – the “relationships, trust and co-operation forged between different groups of people over time”, “the sociological glue that binds diverse societies into a cohesive whole.”    

Andy went on to suggest, “The global financial crisis of the past few years provides a case study of how these capitals, plural, can be decimated by crisis and the toll taken by society”, And he suggested it could be in the dimension of social capital “the losses arising from the crisis may prove most enduring”.

He admitted, “at least until recently many economists like me, when faced with this evidence, might have shrugged our shoulders. Social capital had no real role in our models of economic growth, unlike physical capital and human capital”, adding, “Recently, however, that orthodoxy has changed and the importance of trust has become clearer”.

In explanation he said, “evidence has emerged, both micro and macro, to suggest trust may play a crucial role in value creation. At the micro level, there is now ample evidence the degree of trust or social capital within a company contributes positively to its value creation capacity. At the macro level, there is now a strong body of evidence, looking across a large range of countries and over long periods of time, that high levels of trust and co-operation are associated with higher economic growth. Put differently, a lack of trust jeopardises one of finance’s key societal functions – higher growth”.

Making the link between the loss of trust in finance and the impact on social capital he said, “so a lack of trust in finance potentially hobbles both economic growth and financial stability. That lack of trust is the mirror-image of the perception gap between the financial sector and wider society, the Great Divide”. The Great Divide matters because it signals a pronounced and protracted erosion of social capital. It puts finance on notice for losing its social licence. And, when not addressed, that jeopardises future wealth and well-being.

So, let’s just summarise the problems associated with the situation we find ourselves in, before looking at how we might address them. We have an economy dominated by finance – money making money rather than driving the real economy. This is the result of neoliberal economic ideology and dogma that created financialisaton. And this led to the banking crisis of 2007-8. The consequences have been catastrophic and it is time to ensure the social purpose of finance and banking is restored, and to re-build social capital.  

In addition, it must be said that neoliberal thinking has also dominated the management theories and practices in business, government and the general economy. And as Andy rightly says, “for a growing body of opinion, the short-term, shareholder-centric model of public companies is failing to satisfy the wider needs of society”.

With the publication of the 2018 UK Corporate Governance Code in July, that concern is finally being addressed. It makes clear what the fiduciary duties of directors are to all stakeholders, and that decisions should have a long-term focus. But a change to the Companies Act may also be required. Boards will also need to address many issues to bring about change. For example, the widening gap between the average pay of employees and that of senior executives cannot be justified and the unfairness is damaging. As Haldane explains, it “erodes social capital" And, "a company, like a country, whose physical and social capital is being eroded is one whose wealth-creation capacity is being impaired”.  

Andy goes on to say, “What applies to pay-outs to executives applies, with equal force, to pay-outs to shareholders. Whether as dividends or buy-backs, these too have been on a steadily rising tide over recent decades: from around 10% of profits in the 1970's, to 60-70% today, as short-term shareholder demands have risen steadily. Yet monies paid-out to shareholders are monies also failing to be re-invested in future value creation by the company”.

He concludes by saying, in short, “the shareholder-centric model may have become a recipe for depleting long-term company wealth-creation and, thus, societal well-being”. And, whilst initiatives are trying to address the problem by focusing capital on the long-term, Andy notes it is, “too soon to say whether any of these initiatives will mobilise and catalyse long-term investors sufficiently to exercise leverage over company management in ways which support long-term value creation”.

A major obstacle is, “a dispersed, and too often disinterested, long-term investor base”, resulting from “the falling share of institutional investors in equity ownership, together with the rise of passive investment strategies” which has “exacerbated the trend towards “ownerless corporations””.

He suggests another approach may be, “to seek to reinforce and broaden the “purpose” of companies, to better reflect their broader societal role – their role in serving stakeholders plural (employees, customers, clients) as well as shareholders. Some companies have been able to do so voluntarily by defining clearly their societal purpose and sticking with it. The evidence is that, so purposed, companies create extra value, not just for their staff and customers, but for their shareholders too; it is win-win-win. Indeed, it is win-win-win-win if you throw society into the mix”. And he proposes revisiting the UK Companies Act to give some companies the “helping hand” they may need in this process of changing to better models.

Justifying this change Andy says, “At the time it was introduced in 2006, the Companies Act envisioned an “enlightened” model of shareholder interest which weighed, albeit secondarily, the claims of a wider set of stakeholders, including employees and customers.” And adds, “The experience since has been rather different”. As a result, he suggests, “The time may be ripe for appraising, or re-appraising, these options and others besides, especially in banking where shareholder tensions and short-termism may be particularly acute”.

In my opinion Andy is correct to suggest that changes to the Companies Act are necessary to reinforce and broaden the purpose of companies and their societal role. The recently published Corporate Governance Code and guidance is a step in the right direction, but the law carries more weight. However, there is danger if this process is not managed carefully. The biggest danger is the addition of yet another layer of complexity and confusion. What we need is clarity.

Well intentioned initiatives, both national and international, have produced a wide range of new reporting frameworks which organisations have been encouraged to adopt on a voluntary basis. Most have been designed to provide investors with the information they need to make better investment decisions, extending beyond the financial reports. Some have focused on approaches to the measurement of specific indicators, such as the value of relationships.

Others have developed more complex frameworks that embrace ways to account for multiple indicators which they refer to as capitals. The Integrated Reporting initiative is an example. Then there are others that propose measuring a variety of “impacts”. This started with environmental impacts but has been extended to “total impact” assessments. Arguably the concept of the “triple bottom line” as it became known, was the first such initiative. Twenty-five years old next year, it required organisations to consider people, planet and profit in the course of their activities. John Elkington, the architect of the concept, recently called time on it and plans a thorough review and revision of it during 2019.

Institutional investors, both the asset owners and managers, tell me they are struggling with the profusion, and confusion, of all these frameworks. Even those who wish to adopt them are struggling to see which they should take seriously. That does not surprise me. Whilst some are more advanced than others, I don’t believe any are yet fit for purpose.

My associates and I have been considering how to address this issue. We believe the solution is the formation of a cross-sector advisory panel that represents all key stakeholder groups, to spearhead the design of an open-source research project, and to review and build upon all the existing initiatives and frameworks. The aim being to achieve broad support for one holistic approach. This would result in a generally accepted reporting standard, to supplements, and link to, traditional financial accounting. And this standard would be issued with a reporting code and guidance. The whole would be made available as a public good and could inform the changes to the company laws of nations that are necessary.

We propose the name Social Contract Accounting, the reasons for this and further details are set out in the second part. 

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