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How to avoid conflicts of interests, a lesson from the Sunrise bank

The province of Shanxi, in China, is a remote region near the Mongolia, very far from the sea and its ports. In XIX century, however, it was an important financial centre, and its banks adopted a unique form of corporate governance, useful – according to a paper, The Shanxi banks, written by Randall Morck and Fan Yang at National Bureau of economic research – to avoid conflict or divergence of interests between shareholders and managers.

In XIX century China. it was shameful to resort to formal courts and judges were from landholding classes. For bankers, it was therefore very important to create a “their own contract enforcement system”. At Rishengchang, the Sunrise Provident Bank, they adopted a distinctive system of corporate governance.

They issued two classes of equities, paying the same dividend.

The capital shares were for shareholders, and their price was “equal to the bank’s assets divided by the number of capital shares”. Shareholders bore unlimited liability, and were entitled to participate at the grand assessment day, the general meeting, each fiscal cycle (long three or four years). They could only vote “on the hiring, firing and compensation of managers” and could not influence daily business decisions.

The expertise shares, without voting rights, were instead assigned to professional managers or employees (the insiders), who received salaries too. When not assigned, the expertise shares continued to pay dividends, but into a fund that added to the bank’s assets.

When an insider retired or died on the job, he received dead shares, without voting rights, “which continued paying dividends to him or his designated heir for a period defined in his employment contract”. This motivated the insiders’ long-term thinking. Another rule completed the scheme: wives and children of employees could be taken as hostage by shareholders who, in any case, held too much power (but avoided frauds). This is why the system collapsed.

This corporate governance arrangement is very different form the actual western structure. “In modern corporations – noted Morck and Yang – dual class shares generally give insiders magnified voting power and scant cash flow rights and outsiders primarily cash flow rights, worsening divergence of interests and entrenchment problems simultaneously”. Managers, if control enough votes, cannot be displaced even if they no longer are efficient. “The Shanxi banks also used dual class shares but with the exact opposite configuration: insiders held large equity blocks, but of non-voting shares only – maximizing their cash flows rights to counter divergence of interests problems while bestowing no voting rights at all, thus precluding entrenchment”. Therefore, “managers’ incentives were well aligned with owners’ wealth maximization. Since capital shareholders could not influence lending, their social obligations could not skew lending”.

This is why we can learn from the Shanxi history. “Modern lawmakers, regulator, and firms – wrote Morck and Yang – might consider the Shanxi bank’s approach: Firms might pay insiders expertise shares, with no vote at shareholders meeting. Controlling shareholders might augment their wealth by adopting corporate charter amendments that bar them from influencing business decisions, and let them only hire and fire top executive and set formulas that determine their pay”.