Credit Terms in a Supplier Buyer contracts determine payment delays which accumulate in current accounts of a Firm.
Bank to Bank
Bank to Firm
Firm to Firm
Dyad of Credit Relations
Supplier – Buyer
Triad of Credit Relations
Supplier – Bank – Buyer
Sources of Systemic Risk
Failure of a Firm and its impact on Suppliers and Customers (Flow of Goods)
Failure of a Bank and its impact on Trade Credit
Credit Contraction due to de-risking by the Banks
Decline in Correspondent Banking relations and its impact on Trade Finance
From Credit Chains and Sectoral Co-movement: Does the Use of Trade Credit Amplify Sectoral Shocks?
Trade credit is an important source of short-term financing for firms, not only in the U.S., as documented by Petersen and Rajan (1997), but also around the World. For instance, accounts payables are larger than short-term debt in 60 percent of the countries covered by Worldscope. Also, across the world most firms simultaneously receive credit from their suppliers and grant it to their customers, which tend to be concentrated on specific sectors. These characteristics of trade credit financing have led some authors to propose it as a mechanism for the propagation and amplification of idiosyncratic shocks. The intuition behind the mechanism is straightforward; a firm that faces a default by its customers may run into liquidity problems that force it to default to its own suppliers. Therefore, in a network of firms that borrow from each other, a temporary shock to the liquidity of some firms may cause a chain reaction in which other firms also get in financial difficulties, thus resulting in a large and persistent decline in aggregate activity. This idea was first formalized by Kiyotaki and Moore (1997) in a partial equilibrium setting, and has been recently extended to a general equilibrium environment by Cardoso-Lecourtois (2004), and Boissay (2006) who have also provided evidence of the potential quantitative importance of the mechanism by calibrating their models to the cases of Mexico and the U.S., respectively.
From Ontology of Bankruptcy Diffusion through Trade Credit Channel
A supply network is a network of entities interacting to transform raw material into finished product for customers. Since interdependencies among supply network members on material, information, and finance are becoming increasingly intensive, financial status of one firm not only depends on its own management, but also on the performance and behaviours of other members. Therefore, understanding the financial flows variability and the material interactions is a key to quantify the risk of a firm. Due to the complex structure and dynamic interactions of modern supply networks, there are some difficulties faced by pure analysis approaches in analyzing financial status of the supply network members and the high degree of nonlinear interactions between them. Mathematical and operation research models usually do not function very well for this kind of financial decision making. These models always start with many assumptions and have difficulties modeling such complex systems that include many entities, relationships, features, parameters, and constraints. In addition, traditional modeling and analysis tools lack the ability to predict the impact of a specific event on the performance of the entire supply network. Current financial data analysis with large volumes of structure data cannot offer the full picture and intrinsic insights into the risk nature of a company. Motivated by the literature gap in risk monitoring in investment background and limitations of analysis approaches for handling bankruptcy contagion phenomenon, we propose an ontological approach to present a formal, shared conceptualization of this domain knowledge.
From Inter-Firm Trade Finance in Times of Crisis
The severe recession that is hitting the global economy, with very low or even negative growth rates, has caused widespread contractions in international trade, both in developed and developing countries. World Trade Organization (WTO) has forecast that exports will decline by roughly 9% in volume terms in 2009 due to the collapse in global demand brought on by the biggest economic downturn in decades. The contraction in developed countries will be particularly severe with exports falling by 10%. In developing countries, which account for one-third of world trade, exports will shrink by some 2% to 3% in 2009.
The contraction in international trade has been accompanied by a sharp decline in the availability of trade finance. This decline is only partly explained by the contraction in demand: according to a BAFT (Banker’s Association for Trade and Finance) and International Monetary Fund (IMF) joint survey (2009), flows of trade finance to developed countries have fallen by 6% relative to the previous year, more than the reduction in trade flows, suggesting that part of the fall reflects a disruption of financial intermediation. The contraction in value of trade finance has also been accompanied by a sharp increase in its price. Fear that the decline in trade finance and the increase in its cost would accelerate the slowdown of world trade has triggered a number of government initiatives in support of trade finance (Chauffour and Farole,2009).
The situation is especially worrisome for firms operating in developing countries which rely heavily on trade finance to support both their exports and imports.1 With a restricted access to financing and an increased cost of financing, these firms may find difficulties in maintaining their production and trade activities.
There have been several developments in economics in last 20 years. Although these have been developed by different groups of economists, there are common relations among all of them. Because of Institutional silos, many of these developments are not shared. My attempt is to compile them here in this post and other previous related posts.
IMF Balance Sheet Approach (BSA) – From-Who-To-Whom
Balance Sheet Economics/Asset Liability Matrices (ALM) of Tsujimura
Financial Input-Output Analysis (F-IO Tables)
F-SAM ( Financial Social Accounting Matrix)
Interrelated Balance Sheet Approach of Perry Mehrling and Zoltan Pozsar
Stock Flow Consistent Modeling – Marc Lavoie, G Zezza, W Godley
Extended Supply and Use Tables (E-SUT)/UN SEIGA Initiative
Supply Chain Finance/Financial Supply Chain Management/Operations and Finance
Trade Finance/Global Value Chains/Accounting for Global Value Chains
Integrated Macroeconomic Accounts – NIPAs and Financial Accounts
From Balance Sheets, Transaction Matrices and the Monetary Circuit
Chapter 2 of book Monetary Economics by M Lavoie and W Godley 2007
The lack of integration between the flows of the real economy and its financial side greatly annoyed a few economists, such as Denizet and Copeland. For Denizet, J.M. Keynes’s major contribution was his questioning of the classical dichotomy between the real and the monetary sides of the economy. The post-Keynesian approach, which prolongs Keynes’s contribution on this, underlines the need for integration between financial and income accounting, and thus constitutes a radical departure from the mainstream. 1
Denizet found paradoxical that standard national accounting, as was initially developed by Richard Stone, reproduced the very dichotomy that Keynes had himself attempted to destroy. This was surprising because Stone was a good friend of Keynes, having provided him with the national accounts data that Keynes needed to make his forecasts and recommendations to the British Treasury during the Second World War, but of course it reflected the initial difficulties in gathering enough good financial data, as Stone himself later got involved in setting up a proper framework for financial flows and balance sheet data (Stone 1966).2
In trade relations, if goods flow from X to Y, then Money (Payments) flows from Y to X.
Intra Firm amd Inter Firm relations between Accounts Receivables and Accounts Payable
UNITED NATIONS STATISTICS DIVISION SEIGA Initiative
Under System of Extended International and Global Accounts (SEIGA) Initiative
United Nations is developing:
UN Handbook on Accounting for Global Value Chains
Presentation from 2017 Seminar on Accounting for Global Value Chains
From Financial input-output multipliers
From Sectoral interlinkages in balance sheet approach
From STANDARD DEFINITIONS FOR TECHNIQUES OF SUPPLY CHAIN FINANCE
There are two Areas where FSCM/SCF names are used but in different contexts.
Inter firm FSCM
Intra firm FSCM
Inter firm F-SCM
Supply Chain Finance (SCF)
Value Chain Finance
Inter firm Finance
Collaborative Cash to Cash Cycles Management
During 2008 global financial crisis, the trade financing dried up resulting in decline in trade of goods and services.
Since the crisis, Financial De-globalization and Decline of Correspondent Banking has also made availability of financial credit harder.
Cash flow and working capital management is helped by inter firm collaboration among Suppliers and Buyers.
Financial Institutions which provide trade credit also benefit from inter firm collaboration.
From SUPPLY CHAIN FINANCE FUNDAMENTALS: What It Is, What It’s Not and How it Works
What Supply Chain Finance is Not
The world of trade finance is complex and varied. There are numerous ways to increase business capital on hand and, in many cases, the differences are slightly nuanced. Given this landscape, it’s not just important to understand what supply chain finance is; it’s also important to understand what it is not.
It is not a loan. Supply chain finance is an extension of the buyer’s accounts payable and is not considered financial debt. For the supplier, it represents a non-recourse, true sale of receivables. There is no lending on either side of the buyer/supplier equation, which means there is no impact to balance sheets.
It is not dynamic discounting or an early payment program. Early payment programs, such as dynamic discounting, are buyer-initiated programs where buyers offer suppliers earlier payments in return for discounts on their invoices. Unlike supply chain finance, buyers are seeking to lower their cost of goods, not to improve their cash flow. Dynamic discounting and early payment programs often turn out to be expensive for both suppliers (who are getting paid less than agreed upon) and buyers who tie up their own cash to fund the programs.
It is not factoring. Factoring enables a supplier to sell its invoices to a factoring agent (in most cases, a financial institution) in return for earlier, but partial, payment. Suppliers initiate the arrangement without the buyer’s involvement. Thus factoring is typically much more expensive than buyer-initiated supply chain finance. Also, suppliers trade “all or nothing” meaning they have no choice to participate from month-to-month to the degree that their cash flow needs dictate. Finally, most factoring programs are recourse loans, meaning if a supplier has received payment against an invoice that the buyer subsequently does not pay, the lender has recourse to claw back the funds.
From Mckinsey on Payments
From Financial Supply Chain Management
From Best Practices in Cash Flow Management and Reporting
From STANDARD DEFINITIONS FOR TECHNIQUES OF SUPPLY CHAIN FINANCE
From Financing GPNs through inter-firm collaboration? Insights from the automotive industry in Germany and Brazil
Intra Firm F-SCM
Working Capital Management
Cash Flow Management
Cash to Cash Conversion Cycle Management (C2C Cycle/CCC)
Financial Supply Chain Management (F-SCM) in Manufacturing companies
Financial Supply chain management in financial institutions
Supply Chain Finance
Accounts Payable Optimization
Accounts Receivable Optimization
Operations and Finance Interfaces
Current Asset Management (Current Ratio Analysis)
This is not a new subject. Corporate Finance, Financial Controls, and working capital management have been active business issues. Benefits of Supply chain management include increase in inventory turnover and decline in current assets.
There are many world class companies who manage their supply chains well and work with minimal working capital. Lean Manufacturing, Agile Manufacturing, JIT manufacturing are related concepts. Just-In-Time manufacturing developed in Toyota Corp. reduces inventory portion of C2C cycle. Other examples include
Currently, most of the Supply Chain analytics efforts unfortunately do not integrate analysis of financial benefits of operating decisions.
There are many studies recently which suggest that Cash to Cash Conversion Cycle is a better determinant of corporate liquidity. C2C Cycle is a dynamic liquidity indicator and Current Assets is a static indicator of liquidity. I would like to point out that none of the studies relate C2C cycle with Current Ratio. Current Ratio is based on balance sheet positions of current assets and current liabilities. C2C cycle is based on flows in supply chains. Accumulation of flow results in Current assets (Stock). To make it Stock-Flow Consistent, more work is required.
From Supply Chain Finance: some conceptual insights.
From Financial Supply Chain Management
From The Interface of Operations and Finance in Global Supply Chains
From SUPPLY CHAIN-ORIENTED APPROACH OF WORKING CAPITAL MANAGEMENT
From IMPROVING FIRM PERFORMANCE THROUGH VALUE-DRIVEN SUPPLY CHAIN MANAGEMENT: A CASH CONVERSION CYCLE APPROACH
From IMPROVING FIRM PERFORMANCE THROUGH VALUE-DRIVEN SUPPLY CHAIN MANAGEMENT: A CASH CONVERSION CYCLE APPROACH
From THE CYCLE TIMES OF WORKING CAPITAL: FINANCIAL VALUE CHAIN ANALYSIS METHOD
Call for papers: Supply Chain Finance
Call for papers for Special Topic Forum in Journal of Purchasing and Supply Management (Manuscript Submission: March 31, 2017)
Supply chain finance is a concept that lacks definition and conceptual foundation. However, the recent economic downturn forced corporates to face a series of financial and economic difficulties that strongly increased supply chain financial risk, including bankruptcy or over-leveraging of debt. The mitigation and management of supply chain financial risk is becoming an increasingly important topic for both practitioners and academics leading to a developing area of study known as supply chain finance. There are two major perspectives related to the idea of managing finance across the supply chain. The first is a relatively short-term solution that serves as more of a “bridge” and that is provided by financial institutions, focused on accounts payables and receivables. The second is more of a supply chain oriented perspective – which may or may not involve a financial institution, focused on working capital optimization in terms of accounts payable, receivable, inventory, and asset management. These longer-term solutions focus on strategically managing financial implications across the supply chain.
Recent years have seen a considerable reduction in the granting of new loans, with a significant increase in the cost of corporate borrowing (Ivashina and Scharfstein, 2010). Such collapse of the asset and mortgage-backed markets dried up liquidity from industries (Cornett et al., 2011). In such difficult times, firms (especially those with stronger bargaining power) forced suppliers to extend trade credit in order to supplement the reduction in other forms of financing (Coulibaly et al., 2013; Garcia-Appendini and Montoriol-Garriga, 2013). The general lack of liquidity, in particular for SMEs, has directly affected companies’ ability to stay in the market, reflecting on the stability of entire supply chains. There are many other factors influencing liquidity and financial health that are critical to assess.
These trends and the continued growth of outsourced spend have contributed considerably to the need for and spread of solutions and programs that help to mitigate and better manage financial risk within and across the supply chain. One of the most important approaches is what is being termed Supply Chain Finance (SCF) (Gelsomino et al., 2016; Pfohl and Gomm, 2009; Wuttke et al., 2013a). SCF is an approach for two or more organizations in a supply chain, including external service provides, to jointly create value through means of planning, steering, and controlling the flow of financial resources on an inter-organizational level (Hofmann, 2005; Wuttke et al., 2013b). It involves the inter-company optimization of financial flows with customers, suppliers and service providers to increase the value of the supply chain members (Pfohl and Gomm, 2009). According to Lamoureux and Evans (2011) supply chain financial solutions, processes, methods are designed to improve the effectiveness of financial supply chains by preventing detrimental cost shifting and improving the visibility, availability, delivery and cost of cash for all global value chain partners. The benefits of the SCF approach include reduction of working capital, access to more funding at lower costs, risk reduction, as well as increase of trust, commitment, and profitability through the chain (Randall and Farris II, 2009).
Literature on SCF is still underdeveloped and a multidisciplinary approach to research is needed in this area. In order to better harmonize contributions of a more financial nature with ones coming from the perspective of purchasing & supply chain, there is a need of developing theory on SCF, starting with a comprehensive definition of those instruments or solutions that constitute the SCF landscape. SCF has been neglected in the Purchasing & Supply Management (PSM) literature, although PSM plays a critical role in managing finance within the supply chain. PSM uses many of the processes and tools that are part of a comprehensive supply chain financial program to better manage the supply base, in terms of relationships, total cost of ownership, cost strategies and pricing volatility (see for example Shank and Govindarajan 1992). Reverse factoring is a technique which is also widely used to manage the supply base (Wuttke et al, 2013a) as is supplier development and investment in suppliers.
Research on SCF from a PSM perspective needs further development. In particular, empirical evidence would prove useful for testing existing models and hypotheses, addressing the more innovative schemes and investigating the adoption level and the state of the art of different solutions. Research is also needed for the development of a general theory of supply chain finance. There is also limited research that focuses on the link between supply chain financial tools and supply chain financial performance. Finally, considering the plurality of solutions that shape the SCF landscape, literature should move towards the definition of holistic instruments to choose the best SCF strategy for a supply chain, considering its financial performance and the contextual variables (e.g. structure, bargaining power) that characterize it.
The purpose of this special topic forum is to publish high-quality, theoretical and empirical papers addressing advances on Supply Chain Finance. Original, high quality contributions that are neither published nor currently under review by any other journals are sought. Potential topics include, but are not limited to:
Theory development, concept and definition of SCF
Taxonomy of SCF solutions
Strategic cost management across the supply chain
Total cost of ownership
Life cycle assessment and analysis
Commodity risk and pricing volatility
Supply chain financial metrics and measures
Relationship implications of supply chain finance
Tax and transfer pricing in the supply chain
Foreign exchange and global currency and financing risk
Financial network design and financial supply chain flows
The organizational perspective on SCF and the implementation process
Role of innovative technologies to support SCF ( (e.g. block chain, internet of things)
Supply chain collaboration for improved supply chain financial solutions
SCF adoption models, enablers and barriers
SCF from different party perspectives (especially suppliers and providers)
SCF and risk mitigation and management
Manuscript preparation and submission
Before submission, authors should carefully read the Journal’s “Instructions for Authors”. The review process will follow the Journal’s normal practice. Prospective authors should submit an electronic copy of their complete manuscript via Elsevier’s manuscript submission system (https://ees.elsevier.com/jpsm) selecting “STF Supply Chain Finance” as submission category and specifying the Supply Chain Finance topic in the accompanying letter. Manuscripts are due March 31, 2017 with expected publication in June of 2018.
FOR COMMENTS OR QUESTIONS PLEASE CONTACT THE GUEST EDITORS:
Federico Caniato, Politecnico di Milano, School of Management, firstname.lastname@example.org
Michael Henke, TU Dortmund and Fraunhofer IML, Michael.Henke@iml.fraunhofer.de
George A. Zsidisin, Virginia Commonwealth University, email@example.com
Cornett, M.M., McNutt, J.J., Strahan, P.E., Tehranian, H., 2011. Liquidity risk management and credit supply in the financial crisis. J. financ. econ. 101, 297–312.
Coulibaly, B., Sapriza, H., Zlate, A., 2013. Financial frictions, trade credit, and the 2008–09 global financial crisis. Int. Rev. Econ. Financ. 26, 25–38.
Garcia-Appendini, E., Montoriol-Garriga, J., 2013. Firms as liquidity providers: Evidence from the 2007–2008 financial crisis. J. financ. econ. 109, 272–291.
Gelsomino, L.M., Mangiaracina, R., Perego, A., Tumino, A., 2016. Supply Chain Finance: a literature review. Int. J. Phys. Distrib. Logist. Manag. 46, 1–19.
Govindarajan, Vijay, and John K. Shank. “Strategic cost management: tailoring controls to strategies.” Journal of Cost Management 6.3 (1992): 14-25.
Wuttke, D. A., Blome, C., Foerstl, K., & Henke, M. (2013a). Managing the innovation adoption of supply chain finance—Empirical evidence from six European case studies. Journal of Business Logistics, 34(2), 148-166.
Wuttke, D. A., Blome, C., & Henke, M. (2013b). Focusing the financial flow of supply chains: An empirical investigation of financial supply chain management. International journal of production economics, 145(2), 773-789.
Hofmann, E., 2005. Supply Chain Finance: some conceptual insights. Logistik Manag. Innov. Logistikkonzepte. Wiesbad. Dtsch. Univ. 203–214.
Ivashina, V., Scharfstein, D., 2010. Bank lending during the financial crisis of 2008. J. financ. econ. 97, 319–338.
Lamoureux, J.-F., Evans, T.A., 2011. Supply Chain Finance: A New Means to Support the Competitiveness and Resilience of Global Value Chains. Social Science Research Network, Rochester, NY.
Lekkakos, S.D., Serrano, A., 2016. Supply chain finance for small and medium sized enterprises: the case of reverse factoring. Int. J. Phys. Distrib. Logist. Manag.
Pfohl, H.C., Gomm, M., 2009. Supply chain finance: optimizing financial flows in supply chains. Logist. Res. 1, 149–161.
Randall, W., Farris II, T., 2009. Supply chain financing: using cash-to-cash variables to strengthen the supply chain. Int. J. Phys. Distrib. Logist. Manag. 39, 669–689.
Gantt Chart Simulation for Stock Flow Consistent Production Schedules
I have knowledge of two software which do Gantt chart simulation for production scheduling. These are used by top most companies in the world for production planning and scheduling now a days known as Supply Chain Management (SCM).
Production Schedules are stock flow consistent which means that starting inventories, and unused production of products result in cumulative inventory which is plotted for each of the product.
Production and Shipments (arrivals and dispatched) create Flows and Inventory levels indicate Stock level positions.
Gantt Chart simulators are excellent tools for operations management in plants.
The first Gantt chart was actually developed by Karol Adamiecki in Poland. He called it a Harmonogram. Henry Gantt in 1910 published first gantt chart which was later than publication by Karol Adamiecki.
These two charts below show Simulator window in which Gantt chart and inventory level plots are displayed.
Gantt Chart Simulator in Aspen Tech Plant Scheduler for Production Scheduling
Gantt Chart Simulator in Atlantic Decision Sciences Scheduler
Key Sources for Research:
A Presentation by Chris Jones on Evolution of Graphical Production Scheduling Software
From The Corporate Saving Glut in the Aftermath of the Global Financial Crisis
From Why Are Corporations Holding So Much Cash?
From FACTSET Cash and Investment Quarterly
Companies are holding on to the large sum of cash. Rather than capital investments (CAPEX), cash is being used for share buybacks, dividend payouts, mergers and acquisitions, and cash investments (short and long term).
From FACTSET Cash and Investment Quarterly
Key Sources of Research:
The Corporate Saving Glut in the Aftermath of the Global Financial Crisis
Why do Firms buyback their Shares? Causes and Consequences.
From Stock buybacks: From retain-and reinvest to downsize-and-distribute
Since the late 1980s, in the name of “maximizing shareholder value” (MSV), U.S. corporate distributions to shareholders have exploded. Dividends are the traditional mode of providing a stream of income to shareholders who, as the name says, hold on to a company’s stock, thus supporting stock-price stability. In contrast, stock repurchases, in which a company buys back its own shares from the marketplace, thus reducing the number of outstanding shares, provide short-term boosts to a company’s stock price, thus contributing to stock-price volatility. Until the mid-1980s dividends were the overwhelmingly predominant form of distributing cash to shareholders. Since then, however, even with dividends on the rise, stock buybacks have added substantially to distributions to shareholders.
Over the decade 2004-2013, 454 companies in S&P 500 Index in March 2014 that were publicly listed over the ten years did $3.4 trillion in stock buybacks, representing 51 percent of net income. These companies expended an additional 35 percent of net income on dividends.5 And buybacks remain in vogue: According to data compiled by Factset, for the 12-month period ending December 2014, S&P 500 companies spent $565 billion on buybacks, up 18 percent from the previous 12-month period.6
Stock buybacks are an important part of the explanation for both the concentration of income among the richest households and the disappearance of middle-class employment opportunities in the United States over the past three decades.7 Over that period the resource-allocation regime at many, if not most, major U.S. business corporations has transitioned from “retain-and-reinvest” to “downsize-and-distribute.” Under retain-and-reinvest, the corporation retains earnings and reinvests them in the productive capabilities embodied in its labor force. Under downsize-and-distribute, the corporation lays off experienced, and often more expensive, workers, and distributes corporate cash to shareholders.8 My research suggests that, with its downsize-and-distribute resource-allocation regime, the “buyback corporation” is in large part responsible for a national economy characterized by income inequity, employment instability, and diminished innovative capability – or the opposite of what I have called “sustainable prosperity.”9
From Buyback Quarterly – Factset/December 2016
From Stock buybacks: From retain-and reinvest to downsize-and-distribute
Five years after the official end of the Great Recession, corporate profits are high, and the stock market is booming. Yet most Americans are not sharing in the recovery. While the top 0.1% of income recipients—which include most of the highest-ranking corporate executives—reap almost all the income gains, good jobs keep disappearing, and new employment opportunities tend to be insecure and underpaid. Corporate profitability is not translating into widespread economic prosperity.
The allocation of corporate profits to stock buybacks deserves much of the blame. Consider the 449 companies in the S&P 500 index that were publicly listed from 2003 through 2012. During that period those companies used 54% of their earnings—a total of $2.4 trillion—to buy back their own stock, almost all through purchases on the open market. Dividends absorbed an additional 37% of their earnings. That left very little for investments in productive capabilities or higher incomes for employees.
The buyback wave has gotten so big, in fact, that even shareholders—the presumed beneficiaries of all this corporate largesse—are getting worried. “It concerns us that, in the wake of the financial crisis, many companies have shied away from investing in the future growth of their companies,” Laurence Fink, the chairman and CEO of BlackRock, the world’s largest asset manager, wrote in an open letter to corporate America in March. “Too many companies have cut capital expenditure and even increased debt to boost dividends and increase share buybacks.”
Why are such massive resources being devoted to stock repurchases? Corporate executives give several reasons, which I will discuss later. But none of them has close to the explanatory power of this simple truth: Stock-based instruments make up the majority of their pay, and in the short term buybacks drive up stock prices. In 2012 the 500 highest-paid executives named in proxy statements of U.S. public companies received, on average, $30.3 million each; 42% of their compensation came from stock options and 41% from stock awards. By increasing the demand for a company’s shares, open-market buybacks automatically lift its stock price, even if only temporarily, and can enable the company to hit quarterly earnings per share (EPS) targets.
As a result, the very people we rely on to make investments in the productive capabilities that will increase our shared prosperity are instead devoting most of their companies’ profits to uses that will increase their own prosperity—with unsurprising results. Even when adjusted for inflation, the compensation of top U.S. executives has doubled or tripled since the first half of the 1990s, when it was already widely viewed as excessive. Meanwhile, overall U.S. economic performance has faltered.
If the U.S. is to achieve growth that distributes income equitably and provides stable employment, government and business leaders must take steps to bring both stock buybacks and executive pay under control. The nation’s economic health depends on it.
From Value Creation to Value Extraction
For three decades I’ve been studying how the resource allocation decisions of major U.S. corporations influence the relationship between value creation and value extraction, and how that relationship affects the U.S. economy. From the end of World War II until the late 1970s, a retain-and-reinvest approach to resource allocation prevailed at major U.S. corporations. They retained earnings and reinvested them in increasing their capabilities, first and foremost in the employees who helped make firms more competitive. They provided workers with higher incomes and greater job security, thus contributing to equitable, stable economic growth—what I call “sustainable prosperity.”
This pattern began to break down in the late 1970s, giving way to a downsize-and-distribute regime of reducing costs and then distributing the freed-up cash to financial interests, particularly shareholders. By favoring value extraction over value creation, this approach has contributed to employment instability and income inequality.
As documented by the economists Thomas Piketty and Emmanuel Saez, the richest 0.1% of U.S. households collected a record 12.3% of all U.S. income in 2007, surpassing their 11.5% share in 1928, on the eve of the Great Depression. In the financial crisis of 2008–2009, their share fell sharply, but it has since rebounded, hitting 11.3% in 2012.
Since the late 1980s, the largest component of the income of the top 0.1% has been compensation, driven by stock-based pay. Meanwhile, the growth of workers’ wages has been slow and sporadic, except during the internet boom of 1998–2000, the only time in the past 46 years when real wages rose by 2% or more for three years running. Since the late 1970s, average growth in real wages has increasingly lagged productivity growth. (See the exhibit “When Productivity and Wages Parted Ways.”)
When Productivity and Wages Parted Ways
From 1948 to the mid-1970s, increases in productivity and wages went hand in hand. Then a gap opened between the two.
Not coincidentally, U.S. employment relations have undergone a transformation in the past three decades. Mass plant closings eliminated millions of unionized blue-collar jobs. The norm of a white-collar worker’s spending his or her entire career with one company disappeared. And the seismic shift toward offshoring left all members of the U.S. labor force—even those with advanced education and substantial work experience—vulnerable to displacement.
To some extent these structural changes could be justified initially as necessary responses to changes in technology and competition. In the early 1980s permanent plant closings were triggered by the inroads superior Japanese manufacturers had made in consumer-durable and capital-goods industries. In the early 1990s one-company careers fell by the wayside in the IT sector because the open-systems architecture of the microelectronics revolution devalued the skills of older employees versed in proprietary technologies. And in the early 2000s the offshoring of more-routine tasks, such as writing unsophisticated software and manning customer call centers, sped up as a capable labor force emerged in low-wage developing economies and communications costs plunged, allowing U.S. companies to focus their domestic employees on higher-value-added work.
These practices chipped away at the loyalty and dampened the spending power of American workers, and often gave away key competitive capabilities of U.S. companies. Attracted by the quick financial gains they produced, many executives ignored the long-term effects and kept pursuing them well past the time they could be justified.
A turning point was the wave of hostile takeovers that swept the country in the 1980s. Corporate raiders often claimed that the complacent leaders of the targeted companies were failing to maximize returns to shareholders. That criticism prompted boards of directors to try to align the interests of management and shareholders by making stock-based pay a much bigger component of executive compensation.
Given incentives to maximize shareholder value and meet Wall Street’s expectations for ever higher quarterly EPS, top executives turned to massive stock repurchases, which helped them “manage” stock prices. The result: Trillions of dollars that could have been spent on innovation and job creation in the U.S. economy over the past three decades have instead been used to buy back shares for what is effectively stock-price manipulation.
Good Buybacks and Bad
Not all buybacks undermine shared prosperity. There are two major types: tender offers and open-market repurchases. With the former, a company contacts shareholders and offers to buy back their shares at a stipulated price by a certain near-term date, and then shareholders who find the price agreeable tender their shares to the company. Tender offers can be a way for executives who have substantial ownership stakes and care about a company’s long-term competitiveness to take advantage of a low stock price and concentrate ownership in their own hands. This can, among other things, free them from Wall Street’s pressure to maximize short-term profits and allow them to invest in the business. Henry Singleton was known for using tender offers in this way at Teledyne in the 1970s, and Warren Buffett for using them at GEICO in the 1980s. (GEICO became wholly owned by Buffett’s holding company, Berkshire Hathaway, in 1996.) As Buffett has noted, this kind of tender offer should be made when the share price is below the intrinsic value of the productive capabilities of the company and the company is profitable enough to repurchase the shares without impeding its real investment plans.
But tender offers constitute only a small portion of modern buybacks. Most are now done on the open market, and my research shows that they often come at the expense of investment in productive capabilities and, consequently, aren’t great for long-term shareholders.
Companies have been allowed to repurchase their shares on the open market with virtually no regulatory limits since 1982, when the SEC instituted Rule 10b-18 of the Securities Exchange Act. Under the rule, a corporation’s board of directors can authorize senior executives to repurchase up to a certain dollar amount of stock over a specified or open-ended period of time, and the company must publicly announce the buyback program. After that, management can buy a large number of the company’s shares on any given business day without fear that the SEC will charge it with stock-price manipulation—provided, among other things, that the amount does not exceed a “safe harbor” of 25% of the previous four weeks’ average daily trading volume. The SEC requires companies to report total quarterly repurchases but not daily ones, meaning that it cannot determine whether a company has breached the 25% limit without a special investigation.
Despite the escalation in buybacks over the past three decades, the SEC has only rarely launched proceedings against a company for using them to manipulate its stock price. And even within the 25% limit, companies can still make huge purchases: Exxon Mobil, by far the biggest stock repurchaser from 2003 to 2012, can buy back about $300 million worth of shares a day, and Apple up to $1.5 billion a day. In essence, Rule 10b-18 legalized stock market manipulation through open-market repurchases.
The rule was a major departure from the agency’s original mandate, laid out in the Securities Exchange Act in 1934. The act was a reaction to a host of unscrupulous activities that had fueled speculation in the Roaring ’20s, leading to the stock market crash of 1929 and the Great Depression. To prevent such shenanigans, the act gave the SEC broad powers to issue rules and regulations.
During the Reagan years, the SEC began to roll back those rules. The commission’s chairman from 1981 to 1987 was John Shad, a former vice chairman of E.F. Hutton and the first Wall Street insider to lead the commission in 50 years. He believed that the deregulation of securities markets would channel savings into economic investments more efficiently and that the isolated cases of fraud and manipulation that might go undetected did not justify onerous disclosure requirements for companies. The SEC’s adoption of Rule 10b-18 reflected that point of view.
Debunking the Justifications for Buybacks
Executives give three main justifications for open-market repurchases. Let’s examine them one by one:
1. Buybacks are investments in our undervalued shares that signal our confidence in the company’s future.
This makes some sense. But the reality is that over the past two decades major U.S. companies have tended to do buybacks in bull markets and cut back on them, often sharply, in bear markets. (See the exhibit “Where Did the Money from Productivity Increases Go?”) They buy high and, if they sell at all, sell low. Research by the Academic-Industry Research Network, a nonprofit I cofounded and lead, shows that companies that do buybacks never resell the shares at higher prices.
Where Did the Money from Productivity Increases Go?
Buybacks—as well as dividends—have skyrocketed in the past 20 years. (Note that these data are for the 251 companies that were in the S&P 500 in January 2013 and were public from 1981 through 2012. Inclusion of firms that went public after 1981, such as Microsoft, Cisco, Amgen, Oracle, and Dell, would make the increase in buybacks even more marked.) Though executives say they repurchase only undervalued stocks, buybacks increased when the stock market boomed, casting doubt on that claim.
Source: Standard & Poor’s Compustat database; the Academic-Industry Research Network.
Note: Mean repurchase and dividend amounts are in 2012 dollars.
Once in a while a company that bought high in a boom has been forced to sell low in a bust to alleviate financial distress. GE, for example, spent $3.2 billion on buybacks in the first three quarters of 2008, paying an average price of $31.84 per share. Then, in the last quarter, as the financial crisis brought about losses at GE Capital, the company did a $12 billion stock issue at an average share price of $22.25, in a failed attempt to protect its triple-A credit rating.
In general, when a company buys back shares at what turn out to be high prices, it eventually reduces the value of the stock held by continuing shareholders. “The continuing shareholder is penalized by repurchases above intrinsic value,” Warren Buffett wrote in his 1999 letter to Berkshire Hathaway shareholders. “Buying dollar bills for $1.10 is not good business for those who stick around.”
2. Buybacks are necessary to offset the dilution of earnings per share when employees exercise stock options.
Calculations that I have done for high-tech companies with broad-based stock option programs reveal that the volume of open-market repurchases is generally a multiple of the volume of options that employees exercise. In any case, there’s no logical economic rationale for doing repurchases to offset dilution from the exercise of employee stock options. Options are meant to motivate employees to work harder now to produce higher future returns for the company. Therefore, rather than using corporate cash to boost EPS immediately, executives should be willing to wait for the incentive to work. If the company generates higher earnings, employees can exercise their options at higher stock prices, and the company can allocate the increased earnings to investment in the next round of innovation.
3. Our company is mature and has run out of profitable investment opportunities; therefore, we should return its unneeded cash to shareholders.
Some people used to argue that buybacks were a more tax-efficient means of distributing money to shareholders than dividends. But that has not been the case since 2003, when the tax rates on long-term capital gains and qualified dividends were made the same. Much more important issues remain, however: What is the CEO’s main role and his or her responsibility to shareholders?
Companies that have built up productive capabilities over long periods typically have huge organizational and financial advantages when they enter related markets. One of the chief functions of top executives is to discover new opportunities for those capabilities. When they opt to do large open-market repurchases instead, it raises the question of whether these executives are doing their jobs.
A related issue is the notion that the CEO’s main obligation is to shareholders. It’s based on a misconception of the shareholders’ role in the modern corporation. The philosophical justification for giving them all excess corporate profits is that they are best positioned to allocate resources because they have the most interest in ensuring that capital generates the highest returns. This proposition is central to the “maximizing shareholder value” (MSV) arguments espoused over the years, most notably by Michael C. Jensen. The MSV school also posits that companies’ so-called free cash flow should be distributed to shareholders because only they make investments without a guaranteed return—and hence bear risk.
Why Money for Reinvestment Has Dried Up
Since the early 1980s, when restrictions on open-market buybacks were greatly eased, distributions to shareholders have absorbed a huge portion of net income, leaving much less for reinvestment in companies.
Note: Data are for the 251 companies that were in the S&P 500 Index in January 2013 and were publicly listed from 1981 through 2012. If the companies that went public after 1981, such as Microsoft, Cisco, Amgen, Oracle, and Dell, were included, repurchases as a percentage of net income would be even higher.
But the MSV school ignores other participants in the economy who bear risk by investing without a guaranteed return. Taxpayers take on such risk through government agencies that invest in infrastructure and knowledge creation. And workers take it on by investing in the development of their capabilities at the firms that employ them. As risk bearers, taxpayers, whose dollars support business enterprises, and workers, whose efforts generate productivity improvements, have claims on profits that are at least as strong as the shareholders’.
The irony of MSV is that public-company shareholders typically never invest in the value-creating capabilities of the company at all. Rather, they invest in outstanding shares in the hope that the stock price will rise. And a prime way in which corporate executives fuel that hope is by doing buybacks to manipulate the market. The only money that Apple ever raised from public shareholders was $97 million at its IPO in 1980. Yet in recent years, hedge fund activists such as David Einhorn and Carl Icahn—who played absolutely no role in the company’s success over the decades—have purchased large amounts of Apple stock and then pressured the company to announce some of the largest buyback programs in history.
The past decade’s huge increase in repurchases, in addition to high levels of dividends, have come at a time when U.S. industrial companies face new competitive challenges. This raises questions about how much of corporate cash flow is really “free” to be distributed to shareholders. Many academics—for example, Gary P. Pisano and Willy C. Shih of Harvard Business School, in their 2009 HBR article “Restoring American Competitiveness” and their book Producing Prosperity—have warned that if U.S. companies don’t start investing much more in research and manufacturing capabilities, they cannot expect to remain competitive in a range of advanced technology industries.
Retained earnings have always been the foundation for investments in innovation. Executives who subscribe to MSV are thus copping out of their responsibility to invest broadly and deeply in the productive capabilities their organizations need to continually innovate. MSV as commonly understood is a theory of value extraction, not value creation.
Executives Are Serving Their Own Interests
As I noted earlier, there is a simple, much more plausible explanation for the increase in open-market repurchases: the rise of stock-based pay. Combined with pressure from Wall Street, stock-based incentives make senior executives extremely motivated to do buybacks on a colossal and systemic scale.
Consider the 10 largest repurchasers, which spent a combined $859 billion on buybacks, an amount equal to 68% of their combined net income, from 2003 through 2012. (See the exhibit “The Top 10 Stock Repurchasers.”) During the same decade, their CEOs received, on average, a total of $168 million each in compensation. On average, 34% of their compensation was in the form of stock options and 24% in stock awards. At these companies the next four highest-paid senior executives each received, on average, $77 million in compensation during the 10 years—27% of it in stock options and 29% in stock awards. Yet since 2003 only three of the 10 largest repurchasers—Exxon Mobil, IBM, and Procter & Gamble—have outperformed the S&P 500 Index.
The Top 10 Stock Repurchasers 2003–2012
At most of the leading U.S. companies below, distributions to shareholders were well in excess of net income. These distributions came at great cost to innovation, employment, and—in cases such as oil refining and pharmaceuticals—customers who had to pay higher prices for products.
Sources: Standard & Poor’s Compustat database; Standard & Poor’s Execucomp database; the Academic-Industry Research Network.
Note: The percentages of stock-based pay include gains realized from exercising stock options for all years plus, for 2003–2005, the fair value of restricted stock grants or, for 2006–2012, gains realized on vesting of stock awards. Rounding to the nearest billion may affect total distributions and percentages of net income. *Steven Ballmer, Microsoft’s CEO from January 2000 to February 2014, did not receive any stock-based pay. He does, however, own about 4% of Microsoft’s shares, valued at more than $13 billion.
Reforming the System
Buybacks have become an unhealthy corporate obsession. Shifting corporations back to a retain-and-reinvest regime that promotes stable and equitable growth will take bold action. Here are three proposals:
Put an end to open-market buybacks.
In a 2003 update to Rule 10b-18, the SEC explained: “It is not appropriate for the safe harbor to be available when the issuer has a heightened incentive to manipulate its share price.” In practice, though, the stock-based pay of the executives who decide to do repurchases provides just this “heightened incentive.” To correct this glaring problem, the SEC should rescind the safe harbor.
A good first step toward that goal would be an extensive SEC study of the possible damage that open-market repurchases have done to capital formation, industrial corporations, and the U.S. economy over the past three decades. For example, during that period the amount of stock taken out of the market has exceeded the amount issued in almost every year; from 2004 through 2013 this net withdrawal averaged $316 billion a year. In aggregate, the stock market is not functioning as a source of funds for corporate investment. As I’ve already noted, retained earnings have always provided the base for such investment. I believe that the practice of tying executive compensation to stock price is undermining the formation of physical and human capital.
Rein in stock-based pay.
Many studies have shown that large companies tend to use the same set of consultants to benchmark executive compensation, and that each consultant recommends that the client pay its CEO well above average. As a result, compensation inevitably ratchets up over time. The studies also show that even declines in stock price increase executive pay: When a company’s stock price falls, the board stuffs even more options and stock awards into top executives’ packages, claiming that it must ensure that they won’t jump ship and will do whatever is necessary to get the stock price back up.
In 1991 the SEC began allowing top executives to keep the gains from immediately selling stock acquired from options. Previously, they had to hold the stock for six months or give up any “short-swing” gains. That decision has only served to reinforce top executives’ overriding personal interest in boosting stock prices. And because corporations aren’t required to disclose daily buyback activity, it gives executives the opportunity to trade, undetected, on inside information about when buybacks are being done. At the very least, the SEC should stop allowing executives to sell stock immediately after options are exercised. Such a rule could help launch a much-needed discussion of meaningful reform that goes beyond the 2010 Dodd-Frank Act’s “Say on Pay”—an ineffectual law that gives shareholders the right to make nonbinding recommendations to the board on compensation issues.
But overall the use of stock-based pay should be severely limited. Incentive compensation should be subject to performance criteria that reflect investment in innovative capabilities, not stock performance.
Transform the boards that determine executive compensation.
Boards are currently dominated by other CEOs, who have a strong bias toward ratifying higher pay packages for their peers. When approving enormous distributions to shareholders and stock-based pay for top executives, these directors believe they’re acting in the interests of shareholders.
That’s a big part of the problem. The vast majority of shareholders are simply investors in outstanding shares who can easily sell their stock when they want to lock in gains or minimize losses. As I argued earlier, the people who truly invest in the productive capabilities of corporations are taxpayers and workers. Taxpayers have an interest in whether a corporation that uses government investments can generate profits that allow it to pay taxes, which constitute the taxpayers’ returns on those investments. Workers have an interest in whether the company will be able to generate profits with which it can provide pay increases and stable career opportunities.
It’s time for the U.S. corporate governance system to enter the 21st century: Taxpayers and workers should have seats on boards. Their representatives would have the insights and incentives to ensure that executives allocate resources to investments in capabilities most likely to generate innovations and value.
Courage in Washington
After the Harvard Law School dean Erwin Griswold published “Are Stock Options Getting out of Hand?” in this magazine in 1960, Senator Albert Gore launched a campaign that persuaded Congress to whittle away special tax advantages for executive stock options. After the Tax Reform Act of 1976, the compensation expert Graef Crystal declared that stock options that qualified for the capital-gains tax rate, “once the most popular of all executive compensation devices…have been given the last rites by Congress.” It also happens that during the 1970s the share of all U.S. income that the top 0.1% of households got was at its lowest point in the past century.
The members of the U.S. Congress should show the courage and independence of their predecessors and go beyond “Say on Pay” to do something about excessive executive compensation. In addition, Congress should fix a broken tax regime that frequently rewards value extractors as if they were value creators and ignores the critical role of government investment in the infrastructure and knowledge that are so crucial to the competitiveness of U.S. business.
Instead, what we have now are corporations that lobby—often successfully—for federal subsidies for research, development, and exploration, while devoting far greater resources to stock buybacks. Here are three examples of such hypocrisy:
Exxon Mobil, while receiving about $600 million a year in U.S. government subsidies for oil exploration (according to the Center for American Progress), spends about $21 billion a year on buybacks. It spends virtually no money on alternative energy research.
Meanwhile, through the American Energy Innovation Council, top executives of Microsoft, GE, and other companies have lobbied the U.S. government to triple its investment in alternative energy research and subsidies, to $16 billion a year. Yet these companies had plenty of funds they could have invested in alternative energy on their own. Over the past decade Microsoft and GE, combined, have spent about that amount annually on buybacks.
Intel executives have long lobbied the U.S. government to increase spending on nanotechnology research. In 2005, Intel’s then-CEO, Craig R. Barrett, argued that “it will take a massive, coordinated U.S. research effort involving academia, industry, and state and federal governments to ensure that America continues to be the world leader in information technology.” Yet from 2001, when the U.S. government launched the National Nanotechnology Initiative (NNI), through 2013 Intel’s expenditures on buybacks were almost four times the total NNI budget.
In response to complaints that U.S. drug prices are at least twice those in any other country, Pfizer and other U.S. pharmaceutical companies have argued that the profits from these high prices—enabled by a generous intellectual-property regime and lax price regulation—permit more R&D to be done in the United States than elsewhere. Yet from 2003 through 2012, Pfizer funneled an amount equal to 71% of its profits into buybacks, and an amount equal to 75% of its profits into dividends. In other words, it spent more on buybacks and dividends than it earned and tapped its capital reserves to help fund them. The reality is, Americans pay high drug prices so that major pharmaceutical companies can boost their stock prices and pad executive pay.Given the importance of the stock market and corporations to the economy and society, U.S. regulators must step in to check the behavior of those who are unable or unwilling to control themselves. “The mission of the U.S. Securities and Exchange Commission,” the SEC’s website explains, “is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.” Yet, as we have seen, in its rulings on and monitoring of stock buybacks and executive pay over three decades, the SEC has taken a course of action contrary to those objectives. It has enabled the wealthiest 0.1% of society, including top executives, to capture the lion’s share of the gains of U.S. productivity growth while the vast majority of Americans have been left behind. Rule 10b-18, in particular, has facilitated a rigged stock market that, by permitting the massive distribution of corporate cash to shareholders, has undermined capital formation, including human capital formation.
The corporate resource allocation process is America’s source of economic security or insecurity, as the case may be. If Americans want an economy in which corporate profits result in shared prosperity, the buyback and executive compensation binges will have to end. As with any addiction, there will be withdrawal pains. But the best executives may actually get satisfaction out of being paid a reasonable salary for allocating resources in ways that sustain the enterprise, provide higher standards of living to the workers who make it succeed, and generate tax revenues for the governments that provide it with crucial inputs.
A version of this article appeared in the September 2014 issue of Harvard Business Review.
Key Sources of Research:
Buybacks Around the World
Market Timing, Governance and Regulation
Alberto Manconi Urs Peyer Theo Vermaelen