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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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“Looking out for oneself is a natural, powerful motive that needs little, if any, social reinforcement. […] Altruistic motives, even if they too are natural, are not as powerful: they need to be socially reinforced and nurtured.” If the financial-economic theory accepts the fact that behavioural motivations other than that of wealth maximisation are both realistic and desirable, then the agency problem that economists try to deal with will be a non-problem. For Dobson (1993), the true role of ethics in finance is to be found in the acceptance of the internal good (good in the sense of “right” rather than “physical product”), which, he adds, is what classical philosophers describe as “virtue” – that is, the internal good toward which all human endeavour should strive. He contends: “If the attainment of internal goods were to become generally accepted as the ultimate objective of all human endeavours, both personal and professional, then financial markets would become truly ethical.”

Ethical responsibilities and professional reputation

A distinguishing mark of professions such as medicine and accounting is acceptance of their responsibilities to the public. The AICPA Code of Professional Conduct describes the accounting profession’s public as consisting of “clients, credit grantors, governments, employers, investors, the business and financial community, and others who rely on the objectivity and integrity of Certified Public Accountants (CPAs) to maintain the orderly functioning of commerce”. Many, but not all, CPAs work in firms that provide accounting, auditing, and other services to the general public; these CPAs are said to be in public practice.

Ethics: An Essential Prerequisite 163 Regardless of where CPAs work, the AICPA Code applies to their professional conduct, although there are some special provisions for those in public practice. Internal auditors, management accountants, and financial managers most commonly are employees of the organisations to which they provide these services; but, as professionals, they, too, must also be mindful of their obligations to the public.

The responsibilities placed on accounting professionals by the three codes of ethics and the related professional standards have many similarities. All three require professional competence, confidentiality, integrity, and objectivity. Accounting professionals should only undertake tasks that they can complete with professional competence, and they must carry out their responsibilities with sufficient care and diligence, usually referred to as due professional care or due care.

The codes of ethics of the AICPA, IMA, and IIA all require that confidential information known to accounting professionals not be disclosed to outsiders. The most significant exception to the confidentiality rules is that accounting professionals’ work papers are subject to subpoena by a court; and that nothing analogous to attorney-client privilege exists.

To a large extent, the accounting profession is self-regulated through various professional associations rather than being regulated by the government. The AICPA, the IMA, and the IIA have internal means to enforce the codes of ethics. Furthermore, the professional organisations for CPAs in each state, known as state societies of CPAs, have mechanisms for enforcing their codes of ethics, which are usually very similar to the AICPA Code.

Violations of ethical standards can lead to a person being publicly expelled from the professional organisation. Because of the extreme importance of a professional accountant’s reputation, expulsion is a strong disciplinary measure. However, ethical violations can lead to even more adverse consequences for CPAs because of state and Federal laws.

164 Trust and Ethics in Finance

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There are many occasions when proper business ethics are exercised by organisations and commercial firms that consider themselves socially responsible and viable. Most financial organisations value their investors Ethics: An Essential Prerequisite 165 as a way of exercising ethics in their business. They call this the Human Capital Value. By considering people as their prime asset, businesses around the world scale their way to success. Those involved in the organisation may include employees, investors, stakeholders, contractors and suppliers.

However, in this age of global competition, modern businessmen believe that ethics do not help the business to succeed and prosper, but rather that they limit its resources. The new business age has given birth to a new set of business ethics that are in the best interest of the business itself, these ethics include: valuing diversity, distributed power, reality testing etc. These ethics are further known to be global ethics.

Current trends

Opportunistic agents try to maximise their wealth, even at the expense of others. Since to maximise wealth, agents may act with guile and deceit, agents no longer trust each other. This may for example lead to lenders charging higher rates of interest on their loans because they cannot trust borrowers to invest fully in the most profitable projects. The result is at best a makeshift balance, one that maximises nobody’s wealth. On this point, Dobson (1993) quotes the business ethicist, Norman Bowie: “The conscious pursuit of self-interest by all members of society has the collective result of undermining the interests of all.” In today’s globalised world of finance, where businesses often deal with each other often without any personal contact, the need for enforceable contracts is crucial, if the whole system is to avoid failure.

Furthermore, the problem of enforcing contracts is not purely external to the business. The now prevalent view of the firm is as a nexus of contracts, containing within it people with very different and sometimes conflicting objectives. When one takes this view of the corporation, it begins to look much more like a structured market, structured so as to minimise costs and maximise efficiency.

166 Trust and Ethics in Finance The problem of enforcing contracts is not therefore merely one of the firm’s interactions with other entities, but one that touches the very heart of the firm. Explicit contracts can be enforced through the courts (at a cost), but implicit contracts require trust and mutual good will for their enforcement. It would seem, then, given the importance of contracts for the functioning of the financial system, that building trust could be considered a central ethical requirement.

Trust for trust’s sake is irrational in finance

Unfortunately, the finance paradigm has already decided that to pursue trust for more than merely materialistic, opportunistic ends is irrational. As Dobson says: “But for trust to work, agents must be intrinsically trustworthy. They cannot merely act in a trustworthy manner when it suits their material ends. What is required is trust for trust’s sake. But clearly “trust for trust’s sake” is irrational within the finance paradigm… an individual who forgoes material gain in order to honour some trustbased agreement would be as irrational as an individual who forgoes material gain because the moon happened to be full…. Within the finance paradigm, the act of honouring trust in and of itself has absolutely no value” (italics in the original).

Firms try to create confidence in what they are doing by sending out signals that may or may not convince the market that they are trustworthy. “Good” firms need to send out signals that cannot be mimicked by “bad” firms if they are to be effective. If giving such a signal is not too costly, the good firm that gives it creates a “separating equilibrium” in which it is clear who is who to outside agents. However, such signals do have some cost, and this reduces the efficiency of the good firm. Again, at best we can have a second-best outcome, with a “residual loss” due to the contractual enforcement problem between agents.

Ethics: An Essential Prerequisite 167

Opportunistic agents cannot be trusted

It is important to realise here that we are not dealing with a redistribution of income from principal to agent, but with an absolute loss from which no one gains. Lack of information or “information asymmetry” can make it difficult for principals to know in advance whether they can trust agents, and “moral hazard” describes the situation where it is uncertain whether agents will honour or abuse the trust placed in them. In both cases, proponents of finance theory would argue that firms could build a reputation of trustworthiness that is consistent with the opportunistic and maximising assumptions of the finance paradigm.

Reputation is not well defined in the literature of finance; but by extrapolating from the annual Fortune survey to rank companies by their reputation and a number of other sources: reputation is a behavioural trait. A firm builds its reputation by demonstrating a consistent mode of behaviour through a series of contractual situations. Once built, a reputation increases the value of the implicit claims sold by the firm to stakeholders. Thus, a firm’s desire to earn future profits by maintaining its reputation may act as an implicit contractual enforcement mechanism.

Yet we still hear of financial scandals, even among the most respectable of banks and financial agencies. Furthermore, firms like Salomon brothers that were the subject of a serious fraud, seem to bounce back into action after a short period of re-organisation and knocking heads together. From the point of view of the finance paradigm, there was a fundamental flaw: opportunistic agents cannot be trusted.

Challenging the financial paradigm

The first challenge offered to the finance paradigm comes from the way financial markets themselves operate. After Salomon brothers were involved in stitching up the market for US Treasury bonds, an expert on the incident, Clifford Smith, claimed that Salomon was punished for its 168 Trust and Ethics in Finance unethical behaviour by the financial markets. This implies that there was some moral basis to the punishment, which took the form of economic sanctions incurred by Salomon brothers as a result of the scandal. However, to see whether there was a moral basis to this censure and not purely a financial one, the underlying motivation for the censure needs to be established.

In an indirect way, this information was forthcoming through the approval that the new chief executive, Warren Buffett, received when he stated: “If I hear of an employee losing the company money, I’ll understand. However, if I hear of any employee losing Salomon one shred of reputation I’ll be ruthless!” This statement is important because it separates the loss of reputation from the loss of money, with the implication being that reputation is not purely an instrument used in the maximisation of wealth. In other words, an employee who makes a technical error, losing money for Salomon Brothers, will be treated with understanding, but an employee who sets out to exploit other agents in the market, gaining money for Salomon Brothers but tarnishing the reputation of the firm’s honesty, will be treated severely. This is clearly in open contradiction with the tenets of the finance paradigm.

This discussion still leaves aside the motivation that any given employee might have for not tarnishing the company’s reputation. After all, many would maintain, what matters is what the person does, not why they do it. However, this “practical” argument includes a fatal inherent weakness: “An agent who is not motivated to act ethically will sooner or later act unethically”. The last-ditch stand of the finance paradigm against this thinking is the “confidence school” position: scandals undermine confidence in financial markets, which may reduce the number of participants in the market and reduce the efficiency of the market.

This explains why ethical behaviour is important: it maintains confidence in the market. This justification of ethics only supports the position that unethical behaviour is unacceptable if it undermines confidence Ethics: An Essential Prerequisite 169 in the market. The obvious implication is that if something can be done in such a way as to not undermine such market confidence, the behaviour is acceptable, on condition it maximises wealth.

This connects what may well seem to be a very distant ethical tradition and language to the notion of quality control and procedures, something familiar to all business people in the post-Japanese technological era. It was proven during the industrial revolution that the traditions of business that survived were those that maintained a more virtue-based approach. Only later were these eclipsed by the forms that are more familiar to us today. It has also been proven that businesses that operate on the virtue of ethics and compete efficiently in financial markets, even if there are opportunistic agents. Furthermore, markets cannot operate without such virtuous agents.

When Aristotle described life’s ideal as one of intellectual pursuit or contemplative enquiry, he accepted that the material wealth of his society was sufficient for only a fraction of its inhabitants to realise this ideal. The triumph of our age is that the wealth generated by the firm through the market system has freed the majority of humanity from the fetters of material servitude. But the victory has been Pyrrhic.

Ethics as the essential condition for finance

It would be an understatement to say that the discipline of finance has not been strongly associated with ethics; if anything, the two areas have been opposed to each other as mutually exclusive. Even where such an opposition is not maintained, it remains true that the ethics of finance is underdeveloped compared to the fields of business ethics or professional ethics. Most financiers have not had in-depth ethical training, whereas ethicists lack an understanding of the technicalities of financial management. The situation is thus self-perpetuating.

In recent years, however, following a series of stock market crashes, bank scandals and the present general financial instability, there is a reTrust and Ethics in Finance newed interest in the interface between ethics and finance. Within the field of Catholic Social teaching, an important step was taken in 1994 with the publication of the booklet Modern Financial Systems and the Ethical Imperatives of Christianity (original in French), written by two members of the French Treasury. Its publication followed a series of meetings between top financiers under the auspices of the Pontifical Council for Justice and Peace.

The ethics of finance has thus arrived at an auspicious time, and it merits considerable attention. Its central aim is to show that the theory of finance, with its assumption of self-interested opportunism and maximisation of wealth on the part of every agent, cannot explain what really happens in financial systems. Additionally, taught in a fundamentalist and uncritical way in business schools, the ideology behind the theory of finance leads to the distortion of agents’ behaviour in practice, and the undermining of the proper functioning of a healthy financial system.

It is worth noting that a proper theoretical understanding of finance requires a necessary foundation in some set of ethical assumptions that reach beyond the sphere of technical financial. In other words, an ethical basis to the operation of finance is not a constraint or a limitation placed on financial agents, but rather the prerequisite condition that will allow the financial system to continue to exist.

References Bowie, N., 1991. “Challenging the Egoistic Paradigm”, Business Ethics Quarterly 1.

DeGeorge, R., 1992. “Agency Theory and the Ethics of Agency”, in: Bowie, N.

and Freeman, E. (eds.), Ethics and Agency Theory: An Introduction, New York:

Oxford University Press.

Dempsey, M., 1999. “An Agenda for Window-Dressing or for Radical Change?” Working Paper, Nathan, Griffith University.

Dobson, J., 1993. “The Role of Ethics in Finance”, Financial Analysis Journal, November-December.

Duska, R., 1992. “Why Be a Loyal Agent? A Systematic Ethical Analysis”, in:

Bowie, N./ Freeman, E. (eds.), Ethics and Agency Theory: An Introduction, New York: Oxford University Press.

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