More than five years on from the financial crisis there is still considerable soul-searching about Britain’s economic model. Increasingly the debate concerns not just how much GDP Britain can generate, but how money is made and to whose benefit. A range of companies, from payday lenders to pension funds, have found themselves thrust into the spotlight. This is driven by the sense that, in too many marketplaces, risk has become detached from reward and power has become detached from responsibility.
The ideas set out here explore a new reform principle for responsible capitalism: ‘skin in the game’. The term is often associated with Warren Buffet, who used the phrase to indicate that people investing his money should have some of their own money invested in the same portfolio – they should have skin in the game. We define the term to mean: sharing some of the risks, not just the rewards, when taking decisions with significant implications for others.
This essay draws on a recent article by the academic and author Nassim Taleb and his collaborator Constantine Sandis. The Taleb paper explores the ethical foundations of the skin in the game principle. The authors write that:
About 3,800 years ago, Hammurabi’s code specified that if a builder builds a house and the house collapses and causes the death of the owner of the house, that builder shall be put to death. This is the best risk management rule ever.
What the ancients understood very well was that the builder will always know more about the risks than the client, and can hide sources of fragility and improve his profitability by cutting corners…The builder can also fool the inspector, for the person hiding risk has a large informational advantage over the one who has to find it. The same absence of personal risk is what motivates people to only appear to be doing good, rather than to actually do it.
Taleb and his co-author argue that skin in the game should be treated as a heuristic, or rule of thumb, by individuals making everyday decisions. However, this paper takes the idea a stage further, exploring the potential for skin in the game to be applied as a principle for better regulation across a range of industries.
Before exploring how the skin in the game principle might be applied through public policy, this essay first briefly examines the problem at hand. If there is a need for a more responsible capitalism then it must follow that the model we have at the moment is ‘irresponsible’ in some way. What does this mean?
In their paper, Taleb and his co-author write:
Whatever the best moral theory…the ‘rule’ tells us that we should be suspicious of people who appeal to it to justify actions that pass the cost of any risk-taking to another party whilst keeping the benefits for themselves
The authors argue that ‘moral symmetry’ lies at the heart of some of the oldest and most famous ethical ideas. They offer a collection of examples to make their point.
- Lex Talionis: ‘An eye for an eye, a tooth for a tooth.’ (Exodus 21.24)
- 15th Law of Holiness and Justice: ‘Love your neighbour as yourself.’ (Leviticus 19.18)
- Silver Rule: ‘Do not do unto others what you would not have them do unto you.’ (Isocrates and Hillel the Elder)
- Golden Rule: ‘Do unto others as you would have them do unto you.’ (Matthew 7:12)
- Formula of the Universal Law: ‘Act only in accordance with that maxim through which you can at the same time will that it become a universal law.’ (Kant)
The idea of ‘moral symmetry’ provides a simple way to define responsible behaviour: acting responsibly means treating others as you would have them treat you. Responsibility is therefore closely linked to the practice of reciprocity.
Markets and reciprocity
Markets are designed to promote reciprocity. In theory, if two people freely enter into a transaction then it follows that both expect to benefit from it. Without this mutual benefit both parties would not agree to the deal. In theory, then, market disciplines should align our own interests with those we trade with, encouraging responsible behaviour – the creation of value for others – rather than irresponsible behaviour.
However, in practice there are circumstances under which economic activity might produce negative consequences for others. These include:
People can experience negative consequences from economic activity that they are not involved in. The classic example of this is pollution, which is produced by a company or individual but which generates costs (financial and other) for the rest of society. This is similar to the idea of the ‘tragedy of the commons’ where individuals act according to their own self-interest, but deplete or damage common resources in the process.
People (‘principals’) can experience negative consequences when they task others (‘agents’) to act on their behalf, but the agents do not act in their best interests. An example of this is estate agents who keep their own houses on the market for longer than they advise their clients to. This can happen because estate agents are concerned with getting the very best price for their own house, rather than a quick sale which would allow them to move on to the next customer.
People can experience negative consequences from economic activity when two parties enter into a contract, but one side has an extremely weak bargaining position. This might be due to the absence of alternative options – for example when a company or government has a monopoly over a service – or because people are in a weak position due to other circumstances.
The risk is that the desire to maximise profits – the incentive that drives the many valuable things about capitalism – creates the temptation, within markets, to treat others in ways that we would not have them treat us. The ambition of responsible capitalism should be to minimise this.
Regulating versus reforming markets
When things go wrong there are often calls for more regulatory ‘oversight’, but this assumes that regulators will be able to police business practices effectively. As Friedrich von Hayek argued, it is asking too much to place this burden of oversight on regulators. Sometimes simple standards can be set, but this is not easy in complex markets involving many companies and countless transactions. Regulators will struggle to gather enough information to establish an accurate picture of what each company is doing, let alone what it ought to be doing. Unless the incentives in the market itself change, the danger is that businesses will simply find ways around the rules.
To take the example of the banking sector:
- Governments may establish ‘stress tests’ to gauge whether banks have taken precautions to protect against periods of economic instability. But this assumes that regulators know exactly how to judge the safety of a bank and that banks themselves will present data in a neutral way, without seeking to ‘game’ the system.
- Governments may establish rules on bank bonuses in an attempt to rein in risk-taking in the financial sector. But banks may well respond by finding other methods to remunerate their staff to the same levels, without changing incentives dramatically.
- Governments may worry that loans are being made to people who have little prospect of repaying them. But regulators are unlikely to have an accurate way of establishing who this applies to and who it does not.
As with target-setting in the public sector, the danger is that the organisations comply with the letter of the law, without anything really changing. Frequently regulatory oversight is, therefore, experienced both as burdensome and ineffective at the same time. The answer, according to the economist John Kay, is not to imagine that regulators can do an impossible job, but rather to reform incentives so that they do not have to. Kay argues that:
Effective reform should aim at structures, not at intensified supervision…The most effective supervisors of financial institutions are not bureaucrats but other financial institutions. These principles should be fundamental to a new approach and they have wide implications.
Where possible, governments should therefore seek to reform the incentives in markets rather than attempt to micro-manage the activities of companies. Builders should have the incentive to build safe houses, not just comply with the rules. Banks should have the incentive to invest responsibly, rather than just want to pacify regulators. Understood like this, skin in the game is a structural approach to responsible capitalism.
Although the phrase is not commonplace, skin in the game is an approach already used in policymaking in the UK. For example, guarantees and warranties protect consumers by ensuring that those selling products have skin the game for a set period after a sale is made. Taleb’s ancient builders paid with their lives for cutting corners. The modern version is giving people replacement goods or their money back. This section offers a series of other policy options that policy makers should consider. The examples begin in the financial system, before moving onto issues such as employment practices and infrastructure.
1. Mortgage lending
The proximate cause of the financial crisis was that banks lent money to those who lacked the means for repayment. Some of these were so-called ‘NInJA’ loans – standing for loans made to people with No Income, Job or Assets. Banks were able to make these loans because they could securitise debt, packaging up bundles of mortgages and selling the debt onto others. This meant that the liabilities for the loans would no longer rest on bank balance sheets, allowing for further lending.
In theory this process of securitisation should have provided a natural check on irresponsible lending. Banks ought not to be able to sell on poorly judged loans without making a loss themselves. However, in practice, the incentives were subtly different. Banks had not to worry about poorly judged loans per se, but rather whether these loans could be securitised or not. Banks could suspend their own judgement as long as they could keep passing the liability on to others.
Rather than think of convoluted ways to keep track of who lenders are lending to, the US government has come up with a simpler solution. The Dodd–Frank Wall Street Reform Act specifies that banks must keep 5 per cent of every mortgage loan on their balance sheets – the so-called ‘skin in the game rule’. The purpose is to ensure that lenders focus not just on whether they can sell a loan on, but also whether the borrower will actually be able to pay it back. To encourage responsible lending and to discourage another housing bubble, the skin in the game mortgage rule could be applied in the UK.
2. Company takeovers
There is concern that the takeover regime for companies in the UK has been undermining the performance of individual firms and the economy as a whole. These concerns are linked, in part, to the way in which many takeovers are financed. Most company takeovers in the UK are ‘leveraged buyouts’ – investors borrow some, if not all, of the capital to finance the deal. Once the deal has been completed, this debt becomes the liability of the company that has been purchased, but not the investors making the purchase.
For example, when Malcolm Glazer purchased Manchester United in 2005 for £800 million, over £500 million of the fee was secured against the club’s assets and future income. The club, which was debt-free prior to the takeover, was still £389 million in debt in January 2014. Deals of this type increased in prominence in the run up to the 2008 financial crash, when credit was more readily available.
For investors, this kind of arrangement can create a large potential upside with a limited downside. Investors enjoy the upside if the debt can be repaid, leaving them with a successful business. But investors are protected from the downside if the debt cannot be repaid and the company folds, because those debts are secured only against the assets of the company being purchased.
There are many arguments in favour of company takeovers, including that they can drive efficiency by providing a fresh start for firms that are either underperforming or on the brink of failure. However, there are concerns that the current regime encourages an outlook that is too ‘short-term’ in nature. In particular, ‘leveraged buyouts’ can risk undermining the long-term viability of firms.
As the Bank of England has recognised, when companies take on greater debt they may become more short-termist and more fragile. This is because debt repayments require companies to achieve certain levels of profitability just to survive, let alone invest in the future. As the Bank puts it:
Higher debt levels could make companies less likely to undertake long-term investment if that investment is crowded out by the costs of servicing debt… Higher debt levels could also make companies more likely to default.
In theory, there are incentives to prevent takeover deals that put companies at risk. Banks ought to be reluctant to lend without the reassurance that they will receive their money back and usually require investors to put some of their own money at risk in takeover deals, as the Glazers did with Manchester United.
However, as with mortgages, loans to fund leveraged buyouts are often collateralised – the original lender then sells the debt on to others in the market. As with mortgages, this means that the concern of the lender is primarily whether they will be able to collateralise debt, rather than whether the loans are well-judged per se. This risks making it easier than it should be for investors to acquire loans for buyouts that put companies at risk.
A skin in the game approach could provide more discipline and scrutiny for this kind of takeover. If those lending money to investors were required to keep a (small) proportion of that loan on their own balance sheet, rather than being allowed to sell 100 per cent of the debt onto others, they would have stronger incentives to scrutinise the takeover deal itself. Loans would therefore become harder to come by for those buyouts which put companies at risk over the long-term.
3. Ratings agencies
Ratings agencies played a high profile role during the economic crisis. Products with AAA ratings proved to be far less safe than their ratings suggested, costing not just investors but ultimately the taxpayer too.
Ratings agencies have no statutory role or power. However, in practice, they are influential, affecting the judgements not just of investors but also regulators who have neither the expertise nor the resources to rate every product on the market. The Nobel Prize winning economist Joseph Stigitz has put it this way:
I view the ratings agencies as one of the key culprits. They were the party that performed that alchemy that converted the securities from F-rated to A-rated. The banks could not have done what they did without the complicity of the ratings agencies.
There are concerns over the way ratings agencies are funded. Critics argue that because agencies are funded by the issuers of products they face a conflict of interest. The risk is that under the ‘issuer pays’ model, ratings agencies will try to win business by offering more positive ratings than would otherwise be the case.
In theory, competition ought to provide a counterweight to this. If agencies offer inaccurate ratings then their reputation will suffer and they ought to receive less business as a result. However, research suggests that the funding model may matter. Historical analysis, for example, has found that Standard and Poor assigned higher ratings after it switched from ‘investor-pay’ to ‘issuer-pay’ fees in 1974.
The answer should be to give ratings agencies some skin in the game – their fees should, in part, depend upon the accuracy of their ratings. Under this model, a fixed percentage of the fee for rating a bond would be held back until the moment that the bond being rated comes to maturity. The payment would then be made if the rating was sufficiently accurate.
Operating under this funding model could become a precondition of becoming (or remaining) an accredited agency. Under such a model, it is likely that ratings agencies would be able to borrow against future earnings to address any shortages in cash flow. This would add an additional incentive for accuracy – as ratings agencies’ ability to borrow against future earnings would depend, in part, on their track record for accuracy.
4. Payday lending
There is widespread concern that payday lenders are exploiting the weak bargaining position of those individuals that they lend to by charging extremely high rates of interest. The problem is not so much the initial interest rates of payday loans, but ‘rollover rates’, when people are unable to meet repayment terms. Rates can leap from around 20 per cent to 200 per cent. This can leave individuals with debts that they struggle to pay back, but which can become very profitable for lenders. The result is that lenders have weak incentives either to check that those they are lending to are likely to be able to repay loans, or to negotiate new repayment schedules when borrowers get into trouble.
On 1 April 2014, the FCA took on responsibility for regulating the consumer credit industry. As a consequence payday lenders will be required to pay a levy which is used to fund debt advice to consumers. A skin in the game approach would consider the best way of structuring this levy, so that lenders experience some downside from loans that incur extra interest (above the original rate) for borrowers.
Demos has argued that the FCA should adopt a ‘polluter pays’ approach to the levy. For example, contributions by firms could be based on the number of borrowers repaying loans back at higher than their original terms. This change would encourage lenders to undertake rigorous credit checking before lending to consumer, whilst rewarding those lenders willing to renegotiate the terms of loans, rather than increase rates when borrowers are struggling to repay what they owe.
5. Pension funds
There is widespread concern in the UK that charges levelled by intermediaries in the pensions market diminish the value of people’s retirement pots more than is necessary. Small charges, in percentage terms, can reduce pension pots dramatically over long periods.
For example, someone who initially saves £1,200 in the first year and works for 46 years could lose around £170,000 from their pension pot with a 1 per cent charge and upwards of £230,000 with a 1.5 per cent charge. It therefore matters that employers, who select firms to invest most employees’ pensions, have reason to secure the best deal possible.
In theory employers should want to secure the best deals. Having a good company pension ought to help attract and retain staff. However, the Office for Fair Trading has argued that many employers lack the incentive to do this. This is partly because of the way pension rules have changed. The vast majority of occupational pensions are now ‘defined contribution’ rather than ‘defined benefit’. This means employers only have to guarantee how much they will put into the pension, not how much individuals will be able to draw out at the end of the process. Because employers no longer carry the risk for poor investments, they have weaker incentives to find the best deals.
The challenge is to provide stronger incentives for employers to secure the best deal for their staff. One way to do this would be ensure that company Directors have at least some of their own pensions invested in the same funds as their staff. As things stand, more than 90 per cent of new staff in FTSE 100 companies are enrolled into defined contribution pension schemes while only half, at most, of FTSE 100 Directors have their pensions enrolled in the same schemes (33 per cent simply receive cash payments, while 17 per cent have no occupational pensions, being remunerated simply through salaries and bonuses).
In future, guidelines in the corporate governance code could simply state that all Directors should have the same percentage of their salary invested in the same Defined Contribution schemes that their employees are automatically enrolled into. Directors would not be free to switch into other schemes, to ensure genuine skin in the game. Companies would be free to add to Directors’ pension pots in any way they chose – for example through increased contributions, or cash payouts – but the system would move towards Warren Buffett’s principle that the people responsible for investing your money should have some of their own money invested too.
6. Redundancy pay
When an employee is made redundant they will normally be entitled to a package of pay and benefits. These statutory redundancy payments vary with age, length of service with the employer and pay. The purposes of the payments are to reward service to a company and to protect people from the effects of a sudden loss of income when they lose their job. What these payments do not do is give the company any stake in the future employment prospects of the individual. Should an individual end up out of work in the longer-term, the costs of this are shared between the individual themselves, who is likely to face a drop in income, even when accounting for welfare payments, and society as a whole – which bears the cost of those payments.
However, employers have the power to influence the future employment prospects of their staff, both prior to a redundancy and afterwards. Prior to redundancy, employers have the power to design workplace training which either enhances an individual’s employment prospects, or simply helps them to do their current job better. During a redundancy, employers might be in a position to help staff find new jobs in the same local area or industry, or to provide other forms of support for those losing their jobs, such as help with CVs, interview training or forms of peer-to-peer support. The problem is that employers lack the incentive to take the time to do these things, particularly if they are struggling financially at the time.
A skin in the game approach would give employers a stake in the future of the staff that they make redundant. To achieve this, employers could be required to contribute towards the costs of welfare payments for anyone who is still unemployed a year after being made redundant. This would provide an incentive for more employers to take an active interest in the prospects of those that they are no longer able to employ. Employers would have reason to help staff find new work should they no longer be able to provide employment themselves.
One risk of this policy could be to discourage employers from taking on those with patchy work records. Employers might fear recruiting staff would might struggle to find work in the event of a redundancy. To mitigate this risk, employers could enjoy an exemption from such payments when taking on individuals who had, themselves, previously been out of work for one year or more. Employers would therefore have greater ‘skin in the game’, encouraging them to help prevent long-term unemployment.
7. Sickness pay
When employees face an accident or are too sick to work, they are entitled to Statutory Sick Pay (SSP). Employers must pay £87.55 per week, for up to 28 weeks, before individuals move off employer-funded SSP and onto state benefits. This system is designed to provide some cushion for individuals, who will experience a drop in income while they are unable to work, whilst sharing the costs of sickness absence between the individual, the employee and eventually the state.
However, SSP is often described as ‘dead money’: £87.55 per week provides relatively little incentive for employers to invest time and resources into helping the sick or disabled back into the workplace. As a result, the risk is that people little or no support to return to work and drift onto state benefits after 6 months, at the expense of the taxpayer. The chances of those individuals signed off sick returning to work after a period of six months is only 50 per cent. After one year this drops to 25 per cent. This is bad for the individual, the employer and the public purse – individuals miss out on £4 billion a year in lost earnings, employers pay around £9 billion in sick pay and around 300,000 people flow from work into the welfare system because of health-related issues.
A better approach would give all parties more reason to intervene earlier. Employers could be given more skin in the game through learning from the approach taken in the Netherlands. Under the Dutch system both the employer and the absentee worker must demonstrate that they have done what they can to enhance the chances of the individual returning to work. If the employer is not judged to have made reasonable steps to reintegrate a member of staff, they must continue to pay SSP for up a further year beyond the standard period. These judgements are made by independent physicians, who follow guidance.
A further option would be to act on evidence showing that, on average, those individuals with income protection policies return to work more quickly than those who do not. This is because the insurance companies providing protection against sickness absence have significant ‘skin in the game’, as policies tend to cover up to 70 per cent of an individual’s gross annual salary. Insurers therefore have a clear incentive to invest early in back-to-work support, in order to minimise their own costs through payouts.
Following the success of auto-enrolment in occupational pensions (only around 10 per cent have chosen to opt out of schemes), in future individuals could also be auto-enrolled into income protection policies by their employers. As with pensions, the costs of this could be shared between individuals, employers and the state. In return for this contribution, employers would no longer have to pay out SSP for individuals covered by income protection policies. As with pensions, individuals would have the opportunity to opt out of these policies and rely solely on SSP, but the likelihood is that the proportion of employees with cover would increase significantly. The effect would be to create another party – insurance providers – with skin in the game to help people back to work.
The debate over fracking in the UK polarises opinion. Government ministers are keen to encourage more fracking – the Prime Minister has argued that shale gas has the potential to ‘bring 74,000 jobs, over £3bn of investment, give us cheaper energy for the future, and increase our energy security’, but local residents are often opposed to fracking in their area. This is, in part, because the potential benefits of fracking, such as heightened energy security or cheaper energy prices, are distributed across society, while the downsides, such as noise and disruption to the landscape, are concentrated in local areas.
To address this problem, the Government has sought to give local residents more of a share in the benefits of fracking. Under new plans, local authorities will receive all the business rates collected from shale gas schemes – rather than the usual 50 per cent. In response, councils have argued that the move is a step in the right direction but that the amount is insufficient. The position of the Local Government Association is that, ‘One per cent of gross revenues distributed locally is not good enough; returns should be more in line with payments across the rest of the world and be set at 10 per cent’.
The problem is that this debate over the size of the compensation misses an important point. Companies may be forced to compensate local residents, but they are given no incentive to listen to them, or to take their concerns seriously. A skin in the game approach could change this by giving fracking companies a stake in the interests of local residents.
The rates that fracking companies pay could be indexed to house prices in the area – a proxy for quality of life for residents. If prices in an area plummeted in an area with fracking, but not in comparable areas across the country, the rates paid by the fracking companies would rise. If house prices remained level with other comparable areas it would not. Such a change would encourage companies to see things from the perspective of residents and conduct business in the most considerate way possible.
The skin in the game principle works by reforming the incentives within markets, rather than seeking to micro-manage behaviour within firms. In doing so, it avoids the temptation to expect regulators to know more than is realistic in a complex, modern economy. It also avoids the excessive bureaucracy than can come with this approach. Demos will continue to explore this idea in more detail over the next twelve months.
The idea also has potential applications for public services. For example, in higher education, the right kind of reform could give universities a much bigger stake in their students’ future success. If universities were obliged to provide even a small percentage of the money lent to students through student loans, rather than students borrowing 100 per cent of their loan from the Student Loans Company, universities’ income would be tied more closely to students’ future earnings. This would give universities a much stronger incentive to ensure that students left their institution with the right kinds of skills and support to make the transition from education into work.
Ultimately, the value of the skin in the game idea lies in its ability to align risk and reward, power and responsibility. Whether that is applied in the provision of public services or the reform of private marketplaces, it is an idea surely worth pursuing.