Of late, there has been much discussion of corruption in the public sector of many developing countries. It was inevitable corruption of public servants that, in part, made it important to privatise in developing countries. Advocates of privatisation also lauded the private sector’s ability to compete. But I’m not sure these private sector advocates quite had in mind the abilities that American corporate capitalism has demonstrated so amply recently: corruption on an almost unfathomable scale. They put to shame those petty government bureaucrats who stole a few thousand dollars or even a few million. The numbers bandied about in the Enron, WorldCom, 2G scam, Bofors, Satyam and other scandals are in the billions, greater than the GNP of many countries.
With perfect information (an assumption made by traditional economics) these problems would never have occurred. With perfect information, shareholders would instantaneously have realised that the books were being cooked, and roundly punished the corporate officers. Instead, because of tax advantages and inappropriate accounting practices which received support from the Government and administration, firms were encouraged to reward their executives handsomely with stock options. By this means, corporate officers could ensure that they were extremely well paid, without at the same time taking out anything from the corporation’s bottom line. It was almost too good to be true: while executives were receiving millions, no one seemed to be bearing the cost.
It was a mirage. Shareholder value was being diluted. But it was worse than just being dishonest: stock options provided managers with strong incentives to get the value of their stocks up quickly. What mattered was not long-term strength but short-term appearances. Corporate officers responded to the incentives and opportunities. Over the last 15 years, executive rewards in Inida have soared, and so has the fraction of it which is related to stock prices – to the point where the fraction related to real long-term performance is quite small. Effectively managers have been discouraged from looking at these fundamentals.
Incentives matter. But inappropriate incentives do not lead to wealth creation – they lead to the massive misallocation of resources, the consequences of which America, India or UK is now suffering. Overinflated prices have led firms to overinvest. More generally, when information is imperfect – as it always is (refer to economist Adam Smith’s invisible hand theory) by which the price system is supposed to guide the economy to efficient outcomes, may disappear. With the kinds of incentives that were in place in corporate America, there was a drive for the creation of the appearance of wealth, not for the creation of actual wealth.
By the same token, auditing firms that make more money from consulting than from providing auditing services have a conflict of interest: they have (at least in the short run) an incentive to go easy on their clients or even, as consultants, to help their clients think of ways to improve the appearance of profits – “within” the rules. Analysts at investment banks that earn large fees from stock offerings may, as we have seen, have an incentive to tout the stocks, even when they have their doubts. And if they have a commercial bank division, they may have an incentive to maintain credit lines beyond the level which is prudent, simply because were they to cut them, they risk losing high potential future revenues from mergers and acquisitions and stock and bond issues.
But the problem of incentives can be traced back further: the US treasury had an incentive to urge the continuation of the bad accounting practices (as it did in the mid-1990s): it responds to the interests of Wall Street, and the financial community benefited as much as did the corporate executives from the artificial boom and bubble to which it contributed. The accounting firms had an incentive to try to squelch the Securities and Exchange Commission’s attempt to limit the conflict of interests between their role as auditors and consultants. The banks had an incentive to push the US treasury for the repeal of an act which required the separation of investment and commercial banks.
These examples illustrate the intertwining of public and private incentives: there are private incentives to distort public policy in ways which in turn distort private incentives, and sometimes to prevent public policy from correcting market failures. These problems arise at both the national and international levels. And the public, as they have recognised this vicious nexus, have occasionally taken actions to break or at least weaken it.
It is, for instance, precisely because we worry about distorted incentives of public officials that many democracies have instituted rules against revolving doors. There is a suspicion of government officials who too quickly move to jobs related to their public role. We worry about conflicts of interest in the private sector – accounting firms that make more money from lucrative consulting practices may be soft in enforcement of accounting standards – and in the public. There is a cost to the restrictions intended to limit (though they seldom eliminate) such conflicts of interest. In the case of the public sector, such restrictions sometimes deter qualified individuals from accepting public employment. Such restrictions are imposed because of imperfect information: we cannot really be sure what is motivating individuals. And there is a high cost to the loss of public confidence – a price which in the case of the private sector is reflected in the billions of dollars lost from share value.
Costs to Business
Corruption poses a real business threat to corporations operating in the developing world. Executives have always been concerned about negative PR from corruption, but they are increasingly becoming aware of the additional costs and risks they face, including:
• Operational costs: Corruption adds additional expense throughout the corporate value chain and can lead to costly operational disruptions. Current studies suggest that corruption adds more than 10 percent to the cost of doing business in many countries, and that moving business from a country with low levels of corruption to a country with medium to high levels is equivalent to a 20 percent tax.
•Legal risks: Corporations face substantial consequences if they engage in corrupt business conduct, including large fines and disqualification from future government procurement. For instance, the German engineering conglomerate Siemens recently agreed to pay a record amount in fines to settle bribery cases against the company
• Competitive risks: Companies can also be at a competitive disadvantage if they refuse to pay bribes. Companies that adhere to strict principles against corruption can find themselves losing business to less ethical competitors who are willing to pay to influence the procurement process
We have talked enough about the problem. What about the solution? We envision a world in which corporations become leaders in fighting corruption. To reach that goal, four complementary approaches have been long recommended.
1. Ensure compliance. Corporations should continue to invest significantly in ethics and compliance programs to maintain or increase their level of integrity throughout all divisions and countries.
2. Strengthen collective action. Efforts need to shift from broad-based, diffuse declarations to more outcome-oriented pacts that can create effective incentives for members to change behavior.
3. Engage demand-side forces. While the typical focus of corporate anti-corruption work is on the “supply side” of corruption (the private sector), corporations should expand their efforts to influence the “demand side” (the public sector).
4. Leverage corporate assets. Corporations possess unique and powerful strengths in the fight against corruption, including communications power from the corporate brand, economic leverage, technical expertise, and cash resources for grant-making.
Corporations are currently not organized to execute swiftly on the recommendations made above. A proactive, external-facing approach to fighting corruption has no natural home within a typical corporate structure; as ethics departments are usually staffed with compliance-focused lawyers and most CSR departments do not include anti-corruption work as a priority. To achieve success in the fight against corruption, corporations need to adjust their mindset to include a broader anti-corruption agenda and align and integrate resources and staff for effective execution. Corporations are not a panacea for all the problems the world faces from corruption. However, companies have a business imperative to reduce corruption in critical growth markets and can play an integral role in developing meaningful solutions to this challenge.