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«Global TrusT and EThics in FinancE Innovative Ideas from the Robin Cosgrove Prize Carol Cosgrove-Sacks / Paul H. Dembinski Editors Trust and Ethics in ...»

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108 Trust and Ethics in Finance On a broader level, organisations should seek and internally publish feedback on their business performance including ethical and social performance from clients and industry peers.

Acknowledging and addressing mistakes While the ideas and strategies already covered are tailored specifically to the finance industry taking into account the nature of the industry and its participants, asking people to focus on their biggest mistake may create discussion among much wider group.

Many ethical lapses and litigious situations started with a simple mistake. Instead of acknowledging and addressing the mistake it was concealed leading to further lies and cover-ups, and ultimately to a complex but avoidable situation.

Hence, the necessity to re-train people to feel comfortable in admitting a mistake rather than attempting to conceal it. By looking at examples of mistakes people have made, we can start the cathartic process of acknowledging that as humans we make mistakes and use the information collected as an educative tool.

References CREDO (Centre for Research into Ethics and Decision Making in Organisations), 2005. A Survey of Ethical Value Practices of the Top 200 ASX Listed Companies, Fitzroy, Australian Catholic University.

Persaud, A. and Plender, J., 2007. All you need to know about Ethics and Finance, London, Longtail Publishing.

Singer, Peter, 1979. Practical Ethics, Cambridge, Cambridge University Press.

Surowiecki, J., 2007. “The Financial Page: The Sky-High Club”, The New Yorker, 22 January.


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It is in the very midst of gloom and disappointment that genuine opportunities for success most often come to the fore. Players are forced to sharpen their focus, and chaos puts them more thoroughly to the test.

The very feeling that they must redesign the stage rather than abandon it in mid-crisis allows efficient ideas that are capable of exploring hitherto ignored avenues to flourish.

As the world wallows in an economic crisis of historic proportions, the moment has come to take a new look at financial operators’ motives and guiding principles. Faced with the evidence that the origins of the present slump lay in financial markets, the press and, to an alarming extent, governments have repeatedly denounced professional practices in the sector. Such a climate of tension merely underlines how important it is to identify the true causes of today’s global collapse and take steps to deal with them.

Yet, regardless of its origins, the main factor that is now causing stagnation in the financial sector (and related areas of the economy) to persist is the lack of credibility among its players. Potential creditors and debtors are trapped in a web of profound distrust that is preventing such 110 Trust and Ethics in Finance essential mechanisms as the financing of exports and capital goods from operating as they should.

Although this distrust is largely due to the fact complex riskassessment models have been found wanting, it can be allayed, or prevented from recurring, by more effective guarantees of ethical behaviour. The purpose of this paper, then, is to identify the main areas in which financial firms and operators could comply more fully with ethical standards, thereby restoring credibility within the sector and society’s faith in financiers.

Ethics: The main problem

Every economy needs financial institutions. Through them, savings are transferred to players who require additional injections of funds in order to invest or to cope with a temporary fall in returns without having to cut spending. Nor should it be forgotten that financial institutions meet society’s ever-present need for housing, insurance and shareholder capital.

So, if the financial sector plays a laudable – indeed essential – role, why should financial operators violate ethical standards so often? The most common explanation (Dobbs, 1997) concerns what is known as the agency dilemma. This arises because financial services involve principals delegating the use of their capital to agents. According to the theory of economic rationality, these agents are entirely bent on satisfying their own desire for higher returns, regardless of the consequences. If a particular option offers the agent more opportunity for gain than one that is more profitable for the principal, the agent will be faced with an ethical dilemma.

The Key to Credibility 111

Pro-principal unethical behaviours

There is a crucial flaw in the agency dilemma, for it underestimates the role of agents’ class interests and the importance financial operators attach to long-term gains. If agents fear that unethical choices may have long-term repercussions on their profession’s or firm’s reputation, or indeed their own, they may rationally decide to defer them. To encourage such moral choices, members of the financial sector have created seals of approval for operators well versed in ethical practices, such as the Chartered Financial Analyst (CFA).

The most serious problems for society as a whole lie in kinds of unethical behaviour that do not normally prevent those directly involved from maximising their gains. Indeed, in the short term, many of them generate extraordinary monetary gains for both agents and principals. I will therefore refer to this as “pro-principal” unethical behaviour.

The use of offshore structures to camouflage deficits yielded outstanding short-term gains for Enron shareholders and executives (Enron shares rose 56% in 1999 and 87% in 2000; in the same two years the firm’s Standard & Poor’s 500 rating rose 20% and fell 10% respectively). Investors in Bernard Madoff’s hedge fund Ascot Partners stated that, before the scam came to light, there were consistent double-digit returns and serious reports of wealth creation (Lenzner, 2008).

Even though such operations do not damage the interests of those directly involved – at least, not in the short term – they do reduce society’s faith in the financial sector as well as trust among potential creditors and

debtors, for the following reasons:

(a) they implicitly undermine the authority of social conventions;

(b) they divert resources from activities in the real economy towards financial transactions that are not profitable in their own right; and (c) they tend to even out the risks inherent in transactions involving different kinds of financial assets.

112 Trust and Ethics in Finance Unethical behaviour by financiers for their own benefit and that of their principals is nothing new, nor is it accidental. For centuries, financial advisors have exploited legal loopholes to obtain competitive advantages that enable them to make greater profits than their rivals. In 2003financial centres (especially those in North America) were swimming in liquidity, and high-yield projects were in great demand. All over the world, institutions involved in financial operations often felt tempted to propose uses of capital that, although unethical, would generate outstandingly high returns – and they often found the temptation too great to resist.

The financial sector’s success in providing bonuses, commissions and salaries well above the average in other sectors drew the attention of some of the world’s brightest individuals – doctors, mathematicians, economists, biologists and many others. Lured by the prospect of vast returns, experts from all kinds of fields migrated en masse into financial firms to become vice-presidents, partners and analysts of derivatives, stocks, securities, foreign exchange and so on – an army of often brilliant minds working out how to exploit opportunities that in common-orgarden ethics would be quite out of bounds.

We can categorise four main kinds of pro-principal unethical behaviour: 1) failure to record losses or profits (of whatever kind); 2) creation of subsidiaries to carry out questionable activities; 3) unsupervised transaction clearances; and 4) appointment of project managers who cannot be held accountable for losses.

Failure to record losses or profits Failure to record real values on company balance sheets is a common form of unethical behaviour designed to benefit both agents and principals. Negative values can be omitted in order to boost a company’s share price or reduce premiums on the securities it issues. Positive values, on The Key to Credibility 113 the other hand, can be concealed in order to evade tax or facilitate shareholder or credit control by the manipulating party.

In the 1990s, a number of US companies jointly lobbied Congress to be allowed to omit encumbrances on company capital resulting from employee stock options. The lobbyists argued that any reduction in a company’s book value would adversely affects its market value and so harm its own shareholding employees – whose welfare was the whole purpose of the policy.

The companies were proposing that a real fall in the total value of their assets should be concealed for the benefit of their shareholding staff and executives.

Something similar is now happening with public-private partnerships set up to help certain companies divest themselves of non-liquid assets, regarding the way in which the assets are priced. The companies in question argue that, if the assets are priced by the market, their value will not be sufficient to cover the companies’ urgent need for capital. If, on the other hand, the companies themselves were allowed to price their assets – already due to be purchased with public funds – they could set values high enough to meet their capital requirements.

Once again, noble ends are being used to justify unethical means.

Yet ethics cannot prevail – and hence trust among financial operators cannot be restored – unless the rules of the game (which regulate the means) take precedence over all else. It is an ethical principle that the ends do not necessarily justify the means – and, given that the ends are so often claimed to be laudable, ethical regulation of the means becomes all the more essential.

Creation of subsidiaries When offshore subsidiaries are used to carry out questionable activities, the usual purpose is to help the parent company evade tax. A company sets up branches in other countries where the tax burden is either 114 Trust and Ethics in Finance smaller or easier to avoid (legally or otherwise). The parent company then incurs various fictitious or quite simply unnecessary costs towards its subsidiaries, bringing part of the company’s capital under their control, so that it is subject to less tax. In some cases the subsidiaries are set up for the very purpose of generating costs for the parent company, which can then deduct them from its taxable income in the country of origin. Perhaps the most notorious case of tax evasion via subsidiaries involved the Enron company, which for decades devised ways and means of diverting funds to branches abroad simply in order to avoid paying tax. As so often, this was made easier by the existence of tax havens. In some of these countries the level of bank secrecy is such that legal entities can receive sums of foreign currency anonymously – and so the authorities have no way of checking whether the recipient is in fact a branch of the institution that has paid the money.

Since cracking down on tax havens and bank secrecy is now high on the world political agenda, we can focus instead on what makes companies engage in such illicit activities. The level of taxation in the country where the parent company is based may be considered excessive, damaging to the company’s progress, and hence an excuse for the illicit practice. However, ethical behaviour – as referred to above – has to apply not only to the ends, but also to the means used to attain them.

Unsupervised transaction clearances

The third kind of unethical behaviour can occur because a number of leading operators are authorised to represent both sides in a financial transaction without any need for third-party supervision. One case in which this played a key part was the company set up by Bernard Madoff, an operator who was licensed to conclude transactions without supervision of any kind. This evident lack of transparency eventually gave Madoff the front he needed for a type of financial scam known as a Ponzi scheme.

The Key to Credibility 115 Although such practices are not unethical in themselves, they do give rise to situations in which unethical choices are hard to resist. Having the power to determine the value of a financial transaction, even the most well-intentioned operator will tend to underestimate potential risks and the likelihood of their occurring. The final value of the transaction will then be such that the dividends accruing to the principal – and above all to the agent – will be exceptionally high. The discount on these profits that would normally be required to offset the likelihood of various setbacks occurring will be kept to a minimum, resulting in an artificial transaction and surreal values.

Agents may argue that, by underestimating the damaging effects of the risks involved, they are saving both themselves and their principals unnecessary costs and hence achieving an optimum value for the transaction. However, if one lesson can be learned from the current crisis, it is that risks should never be discounted. The more clearly and accurately the risks involved in a transaction are stated, the less likely it is that values will be distorted and hence that resources will be misallocated.

The main violation of ethical standards resulting from unsupervised transactions is not so much misallocation of resources as misapplication of the rules of the game among operators. Those who are licensed to represent both sides in a transaction are in a position to set much lower costs than anyone else, by minimising the risks involved – not because they are actually able to reduce them, but because of a natural tendency for their interests as sellers to interfere with their decisions as buyers.

Lack of accountability

In the opening years of the twenty-first century, i.e. before the current crisis, the real level of risk accepted by the financial sector became exorbitant. Using a vast array of dazzling instruments, financial institutions (and companies acting as such) devised more and more ways of making highly risky offers to investors. During this period, according to 116 Trust and Ethics in Finance sources in the sector, “anybody who could fog up a mirror could borrow money”. The results are now only too evident: numerous projects were financed at an unacceptable level of risk, and the risks were seldom properly monitored. Countless debts had to be written off, and the executives directly responsible for approving the loans were not held accountable for the monetary consequences.

This scenario was largely due to the fact that the salaries and bonuses paid to the managers responsible for authorising such financing did not depend on the performance of the securities issued by their companies or the instruments on which loans were based. Such lack of accountability – which is the key issue here – is not in itself unethical. Even if executives who approve loans are not exposed to monetary penalties, their behaviour is perfectly ethical as long as they act with due caution and care.

Nevertheless, the fact that those responsible for financing projects were not subject to penalties led them, even unwittingly, to underestimate the scale of the risks involved. With market liquidity at its height, the temptation to offer instruments that allowed excessively risky projects to be financed was simply too strong to resist. Finance thus became available to agents, principals and entrepreneurs whose profiles and ideas would not normally have qualified for it. In reality, the agents who provided it were unethically committing their companies’ resources at lower prices than the risks involved in the various projects would normally have demanded.

Damage to credibility

The four above-mentioned pro-principal unethical practices not only undermine public confidence in the financial sector as a whole, but they also destroy trust between players within the sector.

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