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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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The omission of values on company balance sheets and the use of subsidiaries to avoid penalties or tax clearly undermine respect for the existing rules. Both practices violate accepted standards on such matters The Key to Credibility 117 as tax liability and transparency of corporate finance. They therefore run counter to public expectations that every sector of the economy will comply with socially agreed standards of behaviour. At the same time, they destroy one of the preconditions for trust among financial players and institutions, which is that players in the sector must observe the social conventions on which the rules of the game are based.

On the other hand, the unsupervised transaction clearances and the fact that project managers cannot be held accountable for losses are not in themselves direct violations of accepted standards. Nevertheless, they do damage the credibility of the financial sector by creating situations in which agents will unconsciously tend to behave in socially unacceptable ways. In dealing with conflicting interests, all such agents will tend to underestimate the risks and costs arising from prudent management of the transactions entrusted to them. If unsure whether a particular decision will be made, and in the hope that it will not be, the general public and others involved in the financial sector will tend to give agents the benefit of the doubt – hardly a basis for reliability.

A profitability artificially distorted

The four above-mentioned kinds of pro-principal unethical behaviour have one feature in common: a deliberate intention to distort relative prices within the economy. Corporate balance-sheet omissions and the use of subsidiaries to avoid monetary obligations artificially inflate the market value of certain companies. The fact that some operators are unsupervised and that executives’ incomes do not depend on the decisions they make will, as we have seen, artificially reduce the values of certain transactions to below what they would be if the risks were properly accounted for.

The basic function of the financial sector is to channel savers’ funds towards players whose need for capital, for various reasons, exceeds their present supply of it. There is an optimum state of equilibrium beTrust and Ethics in Finance tween the minimum that savers are willing to accept in return for lending the capital they have accumulated and the maximum that investors are willing (or able) to pay for the capital they borrow.

When the profitability of certain transactions is artificially distorted, more resources are committed to purely financial activities. This means that less capital is channelled towards investment projects in the real economy, such as capital goods or research into agricultural productivity. One symptom of this is that financial operators rapidly grow rich, despite – or even at the expense of – stagnating or slower-growing incomes in other sectors.

This therefore reduces public confidence in financial institutions, since their activities have been visibly extrapolated and their dividends, which should normally be proportional to those earned in the real economy, are in fact growing much faster than the rest.

Partly because of these unethical practices, excess liquidity in the financial sector not only undermines society’s faith in the sector, but also destroys trust among financial players. As the risks involved become more and more evened out, trust among creditors, debtors and intermediaries is eroded.

Market risks and values are evened out

The effect of pro-principal unethical behaviour is to minimise the losses or costs normally faced by companies or investors that seek to comply with ethical standards. The market value of unprofitable companies then approaches that of more cautious ones, and the risks inherent in aggressive transactions appear much the same as in more conservative (but less profitable) ones.

Shrewder market analysts consider this process artificial, misleading, and damaging to the reliability of the financial sector, for there is little way of knowing which companies’ market value is attributable to improved performance and which to massaged balance sheets or illegal use The Key to Credibility 119 of subsidiaries to avoid certain costs, or which transactions involve less risk by their very nature and which have had their risks artificially reduced. In such an atmosphere of uncertainty and distrust, if just one major investor suddenly backs out, a wave of panic may spread among the rest, bringing much of the financial system to its knees.

Restoring credibility through ethics

The main thrust of this essay is that ethical professional behaviour is not only a virtue in itself, but also provides a way to restore society’s faith in financial institutions and trust within the sector itself. Recently, with liquidity at historical levels, countless operators in leading financial markets came up with the most surprising ways of generating exceptionally high returns for their principals. Even though some of these offers did not violate accepted standards of professional conduct, many of them clashed with the demands of common-or-garden ethics. The cumulative impact of such unethical behaviour on the credibility of the financial sector, and on trust within it, was evident from the rate at which investors liquidated their assets in the second half of 2008.

This paper has discussed a number of unethical practices – supposedly win-win games yielding exorbitant profits for both agents and principals – that have helped to destroy confidence in and among financial institutions. It has also looked at the ways in which such operations have contributed to the collapse. What now remains is to suggest ways of discouraging such practices, or at least cushioning their impact on the credibility of the sector.

The recipe proposed here focuses on expanding the notions of transparency and accountability and their application in the financial sector.

Naturally, the more transparently financial companies and institutions operate, the less likely it is that doubts will arise as to their activities or their compliance with ethical principles. Arrangements such as the extraordinary levels of bank secrecy provided by some countries, 120 Trust and Ethics in Finance and the right of certain bodies not to disclose the nature or value of some of their financial operations, help to reduce transparency and increase distrust between major financial players, as well as in the eyes of society as a whole.

Provide financial players with proper information Obviously, legislation requiring a higher level of transparency on the part of financial institutions and other bodies that engage in financial activities would be in the interests of every country’s tax authorities. Such statutory disclosure requirements for financial operations would encourage compliance with ethical standards and help restore trust among players in the sector, as well as society’s faith in it.

It would therefore be a good thing if all the information about every company’s financial operations were to be published, rather than just information concerning taxable sums. Such operations would be subject to scrutiny by the market, allowing it to determine, for its own purposes, whether the risks inherent in a given transaction have been underestimated (and, if so, what the probable reasons are); whether the activities of a given subsidiary are legitimate or merely serve the questionable interests of the parent company; or whether the omission of certain costs is justified or is simply a manoeuvre designed to inflate a company’s market value; and to draw whatever other conclusions it sees fit.

The purpose of this would be to provide financial players (as well as other interested parties within society) with the information they need in order to keep abreast of each company’s activities and the risks it has incurred. This would enable players to place their trust in institutions confidently, rather than just blindly follow the findings of a handful of leading players, based on imprecise reports about key financial transactions.

The Key to Credibility 121

Incentives to act ethically

Accountability is an important tool for increasing the efficiency of operators and companies, and its role in ensuring compliance with ethical principles should not be underestimated. If the operators responsible for each observable element of the process are actually exposed to penalties, the means used to make exceptional profits will also be subject to scrutiny. They will then be less likely to resort to practices that do not violate accepted standards but are nonetheless unethical, simply for their clients’ benefit.

To tackle the fourth above-mentioned kind of pro-principal unethical behaviour, one proposal often made in the media is to tie managers’ bonuses and salaries to the performance of the securities issued by their companies. Those responsible for issuing loans will then have a strong incentive to assess the risks inherent in each proposal carefully, since these may do serious damage to their company’s position.

One fundamental economic axiom is that people respond to incentives. One way to ensure accountable, responsible behaviour in the long term would be to give players incentives to act that way, rather than merely call them to account after the event. This will mean looking closely at financial operators’ personal motives, as well as supervising their activities properly.

Corporate cultures that set out to make employees’ personal ambitions coincide with company goals undoubtedly tend (assuming that both are legitimate and ethical) to encourage ethical decision-making.

Executives who feel they are part of a team whose work takes account of and helps them attain their own goals will be more inclined to take responsibility for what they do, and hence more likely to work more diligently.

To ensure proper supervision of compliance with ethical standards, under a system of duly attributed accountability, companies can also make use of incentives aimed at the relevant players. One such instruTrust and Ethics in Finance ment would be to distribute the penalties imposed for violations of the rules, or for loss of market value, among all the members of the department responsible. Although this may create a climate of hostility and suspicion within each department, it will also give all the players involved the same incentive to find ethical solutions to dilemmas faced by their colleagues.

A long road ahead

Although the links between ethical behaviour and credibility are obvious, the task of analysing how both can be achieved more (or less) effectively is almost endless. This paper has described how, in the midst of the present crisis, failure to comply with ethical standards – and the resulting lack of credibility – have reached a critical point. The new systems of financial regulation that are now being set up will certainly take account of the need to guarantee ethical behaviour, in the interests of greater predictability and credibility among financial players.

For the time being, the public’s focus on every last detail of government plans to bail out financial institutions goes to show just how low the sector’s reputation has now sunk in society’s eyes. The road towards restoring confidence among creditors, debtors and operators will be long and winding, but it is a road that must be travelled. However, the task of consolidating ethical behaviour in a sector that is currently in such desperate need of public funding is proving just as hard.

References Dobbs, J., 1997. Finance ethics: the rationality of virtue, New York, Rowman & Littlefield.

Lenzner, R., 2008. “Bernie Madoff’s $50 Billion Ponzi Scheme“, Forbes, 12 December.



–  –  –

A description of the current financial crisis does not need to be repeated here. The reverberations of a failed global financial system will be felt for years, if not decades. The reasons for the felling of our global economic system are innumerable. There were many perpetrators, and many more victims still. While retrospective analysis is essential, of far greater import at this juncture in time is understanding how to avoid future transgressions of this scale and impact. Will greater Securities and Exchange Commission (SEC) oversight, mortgage bank policies, or more thorough investigative journalism help us avoid future similar calamities?

These and all similar efforts would not have prevented the current crisis, nor will they, or other prescriptive solutions, prevent future upheavals. Rather, in discussing the bank leverage, collateralised mortgage obligations, or foreign exchange rate, we need to remember that the core of these institutions and concepts are not laws, corporate charters or global treaties. At the core, the financial system was developed by, is stewarded by, and is fully dependant on human decision-making.

124 Trust and Ethics in Finance Before we create a new financial system, with new loopholes for the creative greedy to slip through, let us ask ourselves: what leads people to act? How do they choose one action over the other? And, are we able to structure our financial system in a way that might encourage ethical behaviour?

The current state of crisis within the financial marketplace exists, in large part, because of a detachment between personal ethics and the professional life.

Who are we?

In 1971, researchers at Stanford University conducted the Stanford Prison Experiment. In this experiment, undergraduate students were assigned either the role of prisoner or guard through the luck of a coin toss. If they were to become guards they were given wooden batons, uniforms and reflective sunglasses. If they were to become prisoners, they were “arrested” at home, stripped of their personal belongings and reassigned identification numbers. The guards, while cautioned not to physically assault the prisoners, were given full power over them. All students participating in the study were screened ahead of time for psychological stability.

This experiment had to be terminated after six days. Conditions had become unsafe for the prisoners. More than a quarter of the guards were deemed to be exhibiting sadistic or dangerous tendencies. This same phenomenon, where ordinary citizens act with extreme cruelty, has, unfortunately, been observed in far less benign situations, such as Abu Ghraib. While it may be reassuring to view the perpetrators of these injustices as aberrations of humanity, the truth is far less reassuring.

In reviewing these and similar scenarii, psychologists have identified a number of elements that contributed to the abuses perpetrated. These included disorientation, depersonalisation and de-individualisation of the Emotions, Personal Ethics and Professional Life 125 victims. Within the prison experiment, authoritarian roles were institutionalised, with a strong power dynamic emphasised.

Understanding, and accepting, the human psyche To change the financial system, to imbue it with ethics, we must do more than write new rules. We must understand and address who we, as humans, truly are. Rather than discuss idealised versions of the self, we must first acknowledge the capacity for evil and cowardice that exists within all – not just financiers.

We must assume that “good” people have been involved in past finance scandals and ethical transgressions. These perpetrators most likely experienced a level of cognitive dissonance. Cognitive dissonance occurs when holding two conflicting ideas leads to the justification or rationalisation of attitudes or behaviours that would otherwise be considered unethical. This assumes a struggle within the self around ethical beliefs.

To some extent cognitive dissonance is a daily experience. We know that driving is expensive, bad for our health and the environment. But, we have groceries to carry home. Or we need to be somewhere quickly.

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