The New Mutualism in Public Policy

Johnston Birchall

• Publisher: Taylor & Francis
• Year: 2002
• Print ISBN: 9781138994430
• eBook ISBN: 9781134549467
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

Mutuality has become a topic of debate recently for a whole range of academics and social commentators. The 'demutualisation' of banks and building societies has been partnered by the idea of a 'new mutualism', forming a set of social values and beliefs, and this collection looks at the manifestations of these trends and the implications for the future.

1 The economics of mutuality

A perspective on UK building societies

Leigh Drake and David T. Llewellyn

The mutual corporate form is very prevalent in financial services but much less common in other non-financial business areas. Mutual institutions have generally dominated housing finance and life assurance markets, both in the UK and in many other developed economies such as the USA. This has been particularly true in the UK housing market, where mutual building societies have traditionally dominated the mortgage market, even after the intensification of competition that followed deregulation and the entry of banks and wholesale-funded lending institutions in the early 1980s. Not only have mutual institutions tended to dominate certain segments of the financial services market, but they have also tended to enjoy a superior public image over their joint stock company or plc counterparts and to compare very favourably in terms of performance measures such as relative profitability and cost/income ratios. This is especially true in respect of the contrast between UK building societies and banks.

A powerful trend has emerged in recent years, however, towards demutualisation; that is, mutual financial institutions converting to plc status. This trend has been particularly evident in the housing finance and savings bank sectors of many ‘Anglo-Saxon’ economies such as the USA, Australia, New Zealand and South Africa. The UK had seemed to be largely immune from this general trend prior to 1995, with only the Abbey National building society taking advantage (in 1989) of the conversion option introduced under the 1986 Building Society Act. However, the mid-1990s witnessed a wave of plc conversions by UK building societies. The Cheltenham and Gloucester building society was acquired by Lloyds Bank, and a number of other building societies, such as the Halifax (which merged with the Leeds Permanent in 1995), Woolwich, Alliance and Leicester, and Northern Rock, all converted to plc status during 1996/97. These conversions amounted to a very significant demutualisation, with over 65 per cent of the sector’s assets being transferred to the plc sector.

More recently, the boards of other UK building societies, such as the Nationwide and Bradford and Bingley, have been forced to hold votes on plc conversion motions following pressure from members. In the case of the Bradford and Bingley, this pressure forced the board to change from a pro-mutual to a pro-plc stance, and in July 2000, the members voted overwhelmingly for conversion: 94.5 per cent of saving members and 89.5 per cent of borrowers supported the conversion option. This vote leaves the Nationwide as the sole remaining large mutual building society. There is also evidence that a similar trend is emerging in the life assurance sector, with the Norwich Union and Scottish Widows being the latest and most significant mutuals to announce a plc conversion. In the case of Scottish Widows, this conversion is via an acquisition by Lloyds TSB. Furthermore, the board of Standard Life, the UK’s largest mutual life assurance company, only narrowly fought off a conversion challenge mounted by a member.

This apparent trend towards demutualisation in the UK has, not surprisingly, brought the ‘mutual versus plc’ debate sharply into focus. A key element in this debate typically centres around the differences in ownership structure and the often alleged greater scope for managers of financial mutuals to engage in rent seeking or expense preference behaviour. In other words, it is typically asserted that agency costs are more serious in mutuals than in plcs because the owners (investors and borrowers) of the former have less influence on managers than do their equity shareholding counterparts. The purpose of this chapter, therefore, is to draw on the vast literature relating to property rights, corporate ownership structure and agency costs in order to cast an objective light on these issues in respect of financial services and, in particular, UK building societies. Aside from providing insights into the recent pressures inducing mutuals to convert to plc status and addressing the economic and welfare issues relating to this trend, this literature should also provide insights into why mutuals have traditionally dominated certain sectors of the financial services marketplace and have competed very successfully alongside plcs in these areas for many years.

The purpose of this chapter is not to make a case for one form of corporate structure over another. There are good reasons why different corporate forms may coexist within the same marketplace (and indeed there may be clear advantages in such a diversity of corporate form), and there are clear economic rationales for the predominance of certain corporate forms, such as mutuals, in cases where institutions are relatively narrowly focused on providing long-term financial products such as mortgages and life assurance. Similarly, the literature on property rights and ownership structure can help to explain why relatively risky and highly diversified activities, such as commercial banking, tend to be dominated by plc or stock corporate forms.

The theory of the firm

A useful starting point in the analysis of the economics of mutuality is to recognise that mutuals are economic firms, organisations that use resources to add value in the creation of goods and services. In this regard, a mutual is one among many types of economic firm: sole proprietors, closed companies, partnerships, plcs, co-operatives, state owned agencies, etc. Different types of firm often compete with each other in the same markets. Mutuals are therefore one of many forms for organising economic activity. Each type of economic firm has its own strengths and weaknesses, which is why different organisational forms are able to co-exist, and sometimes in direct competition with each other.

A particular problem relating to the economic analysis of mutuals, however, is that they are typically contrasted against inappropriate or unrealistic benchmark corporate forms. Boxall and Gallacher (1997), for example, in their analysis of mutuality, elect to use the model of a profitmaximising firm as ‘the obvious standard of comparison for an economist’ (p2). If we refer back to the traditional or classical theory of the firm, however, this tended to focus on the role of the entrepreneur, or owner-manager, and it was they who were presumed to operate the firm so as to maximise profits. As Jensen and Meckling (1976) point out, however, the classical theory of the firm really relates to the theory of markets (perfect competition, monopoly, etc.) in which firms are important actors. As they put it, ‘the firm is a ‘‘black box’’ operated so as to meet the relevant marginal conditions with respect to inputs and outputs, thereby maximising profits, or more accurately, present value’ (p306).

It is clear that, in practice, modern large corporations bear little resemblance to the classical entrepreneur, and this has spawned a wealth of literature dating back to Adam Smith (1776) and Berle and Means (1932) concerned with the incentive problems that can arise when firms are run by managers who are not the owners or security holders of the firm. This is the so-called ‘agency problem’ in firms which is generally characterised as a problem emanating from the separation of ownership and control. More precisely, Fama and Jensen (1983) argue that agency problems can arise in any organisation in which there is a separation of decision-making and risk-bearing functions such that important decision agents do not bear a substantial share of the wealth effects of their decisions.

Potential conflicts of interest (between managers and owners) arise because contracts are necessarily incomplete: it is not feasible to set down in advance a set of complete contracts that specify courses of action for each stakeholder in all conceivable future circumstances. There necessarily must be discretion, but the discretion of managers can be abused. Hart (1995) notes that corporate governance issues arise when: (1) agency problems (conflicts of interest) arise within a firm; and (2) transactions costs are such that the problem cannot be dealt with through explicit contracts. Also in this context, Fama and Jensen argue that agency problems arise because contracts are not costlessly written and enforced. Agency costs include the costs of structuring, monitoring and bonding a set of contracts among agents with conflicting interests. Agency costs also include the value of any outputs lost through the fact that the costs of full enforcement of contracts are greater than the benefits. Clearly, therefore, agency problems can arise in both plc banks and mutual financial institutions such as building societies.

The initial response to these perceived agency problems was to abandon the notion of the classical entrepreneur and of profit maximisation, and to focus on the motivations of managers who run, but do not own, firms. This resulted in the development of managerial theories of the firm (Baumol, 1959; Cyert and March, 1963; and Williamson, 1964) which fostered the notion that agency problems may manifest themselves in costs associated with managers’ rent-seeking behaviour. Such expense preference behaviour is usually argued to take the form of non-salary perquisites such as ‘excessive’ office expenditure, business lunches, travel expenses, etc. Not surprisingly, this strand of literature has spawned a wealth of empirical research investigating the degree of expense preference behaviour in financial institutions. A particularly active strand of this literature involves contrasting the relative extent of expense preference behaviour in regulated and deregulated industries, and in cases where different corporate forms co-exist in large numbers in the same market place. Examples of the latter include the numerous investigations into expense preference behaviour in mutual and stock (plc) Savings Banks and Savings and Loan Associations (S & Ls) in the USA.

A more recent development in theory of the firm literature, however, rejects the classical model of the profit-maximising firm in favour of models that emphasise classical forms of maximising behaviour on the part of the various agents making up the firm (Alchian and Dempsetz, 1972; Jensen and Meckling, 1976; Fama, 1980; and Fama and Jensen, 1983). Because of the emphasis on the importance of rights established by contracts within an organisation, this literature is often described under the rubric ‘property rights’. This emphasis on property rights and contracts is very evident in the definition of a firm (organisation) offered by Fama and Jensen (1983):

An organisation is the nexus of contracts, written and unwritten, among owners of factors of production and customers. These controls or internal rules of the game’ specify the rights of each agent in the organisation, performance criteria on which agents are evaluated and the payoff functions they face. The contract structure combines with available production technologies and external legal constraints to determine the cost function for delivering an output with a particular form of organisation. The form of organisation that delivers the output demanded by customers at the lowest price while covering costs survives. (p302)

Fama and Jensen also point out that agency problems occur whenever the separation of decision-making and risk-bearing functions is observed, and hence are common to large corporations, large professional partnerships, financial mutuals and non-profit organisations. Clearly, the prevalence of the separation of decision-making and risk-bearing functions in large institutions can readily be explained by the benefits of specialisation (specialised managers, security holders, etc.). If the agency costs that allegedly follow from this separation are to be squared with the assertion that only low-cost producers survive in the long run, however, then these institutions must find a common approach to controlling such agency problems. This is particularly pertinent in respect of financial mutuals, such as UK building societies, since it is often asserted that agency problems are more severe in mutuals than in plcs. According to Fama and Jensen (1983), this common approach ‘is that the contract structures of all of these organisations separate the ratification and monitoring of decisions from initiation and implementation of decisions’ (p302).

Drawing on the structure and theoretical insights provided by the property rights literature, therefore, the remainder of this chapter attempts to answer some key questions central to the current mutuality versus plc debate in respect of UK building societies. First, given that low-cost producers can be expected to survive in the longer run, and that agency costs are allegedly more severe in financial mutuals, how do we explain the prevalence of mutuals in the financial sector and particularly in certain sub-sectors such as the mortgage and life assurance sectors? In other words, are there features of the mutual corporate structure which make them particularly suited to these types of product markets? Second, given that agency problems potentially affect both plc and mutual financial institutions, how do they compare across the two corporate forms, and what are the ‘common approaches’ adopted by these institutions in order to curb the associated agency costs? A further related issue is to examine the relative levels of expense preference behaviour across financial mutuals and plcs, and the extent to which this is influenced by other factors such as the degree of competition in the market place. Clearly, the extent of any measured residual agency costs (such as expense preference behaviour) evident in each corporate form will be the net outcome of the gravity of the underlying relative agency problems and the effectiveness of any control measures adopted. Finally, this chapter will attempt to identify specific factors that have influenced the current trend towards demutualisation in UK building societies, and provide some tentative insights into possible future trends in the industry.

Mutuals in the financial services sector

Within the ‘nexus of contracts’ paradigm established under the property rights literature, any firm is simply a set of contracts among the various factors of production, agents or ‘stakeholders’ within the organisation. Clearly, within this paradigm there are many alternative ways in which these sets of contracts can be structured and the mutual form is simply one among many possible corporate forms. That being said, the prevalence (and long history) of mutuals in the financial sectors of many economies, together with their relative scarcity in non-financial sectors, is suggestive of the fact that mutuality may be particularly suited to the provision of financial services, and particularly those relating to longer-term contractual relationships such as mortgages and life assurance. This may be a result of: an inherent efficiency advantage in this area; or the greater ability of financial, as opposed to non-fi...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright Page
• Table of Contents
• List of figures
• List of tables
• Notes on the contributors
• Introduction
• 1 The economics of mutuality: a perpective on UK building societies
• 2 Mutuality through credit unions: a cross-national approach
• 3 Housing co-operatives and social exclusion
• 4 Consumer co-operatives in retrospect and prospect
• 5 Mutuality and public services: lessons from the ‘new leisure trusts’
• 6 Mutuality in insurance and social security: retrospect and prospect
• 7 Farmer co-operatives: organisational models and their business environment
• 8 Mutuals in regional economic development: Mondragon and Desjardins
• 9 The competitive advantages of stakeholder mutuals
• 10 Member participation in mutuals: a theoretical model
• 11 The new mutualism and Labour’s Third Way
• Conclusion: the future of mutuality
• Index