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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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Ethical problems while dealing with risk arise when – in the event of the materialisation of the risk – those bearing the risk suffer a loss of welfare that infringes their rights to individual goods such as physical integrity, well-being and the right to pursue their projects. A systemic financial crisis can involve a massive infringement of rights as it is no more assured that the rights of individual agents are protected. Due to the fact that the breakdown of financial markets can result in extremely adverse effects, institutions both governmental and non-governmental, may be prevented from securing the conditions needed to insure common and public goods. As a matter of fact, there is usually no compensation paid to the ones actually harmed. The process of carrying out the payments and ascertaining the appropriate compensation would involve enormous transaction costs. Besides, often it is impossible to identify the Financial Derivatives and Responsibility 219 risk imposer as we are dealing with cumulative and multidimensional risks. A well-functioning financial market is therefore morally relevant as it is an indispensable element for the protection of rights. With reference to derivatives, we have to make sure that there are certain negative events that must not be risked and ought to be prevented if possible even if the probability of their occurrence is low. We need detailed considerations and analyses, especially on the impact of derivatives on systemic risk. This is also important as the financial crisis 2007/08 made obvious some upsetting deficits in risk management. Systemic risks caused by financial innovations were neglected. In addition to that, the assumptions in the estimations and calculations of risk were in many cases unwarranted as they portrayed the illusion of being able to make reliable estimations and calculations of probability. The problems cannot always be traced to the derivatives as such. Often, ultimate failures of the top management, who do not see through complicated derivatives transactions, lead to financial catastrophes, as the Barings case illustrates. In order to deal responsibly with financial risk we need to be aware of the fact that the creation and dispersion of risk is ethically relevant, even before a financial catastrophe occurs.

Three guidelines for dealing ethically with financial risk

Risk is absolutely central to derivative instruments as well as to the handling of them. The reason we need to care about derivatives lies in their ability to provide tools for the management of risk, as well as in their power to fuel the individual and – most importantly – the systemic dispersion of risk. Systemic risk can be catastrophic for an economy as it may lead to a system collapse and the violation of fundamental human rights. We need guidelines that help prevent systemic crises, providing

precautionary methods both for the micro- and the macroethical level:

1. Avoidance of systemic risk

2. Distinguishing risk-generating from risk-dispersing instruments 220 Trust and Ethics in Finance

3. Transparency through oversight

The avoidance of systemic risk First, we need macroprudential insight that should focus on the financial system as a whole and that seeks to avoid and at least to minimise system-wide distress. We need to understand that risk is endogenously created and transported through the system. Surveillance needs to be accomplished internationally as market participants act on a global level. As far as derivatives are concerned, their impact on the systemic level of risk is still unclear. Further research is required by scientists as well as finance practitioners and professionals in order to bring to light which derivative transactions on the microethical level pose a cumulative risk to the well-functioning of the entire system. By integrating the concept of systemic risk avoidance into theory and practice, calibrations and models of risk would have to be adjusted.

Distinguishing risk-generating from risk-dispersing instruments Second, we need to develop methods to distinguish risk-generating from risk-dispersing derivative instruments. Whereas carefully chosen derivative deals may reduce the risk inherent in doing business, there are transactions that can provide powerful leverage mechanisms for creating risk with a negative influence on economic stability. More risk can be created for example when by hedging some risks, individual investors gain exposure to another risk. In addition to that, derivatives can also be risk-generating when the risk involved in the transaction is concentrated not among those most capable of bearing it, but among those most willing to take it. Individual traders and institutions may be too confident to bear massive risk jeopardising the welfare of the system.

The second guideline focuses mainly on connecting the micro-ethical and the macro-ethical sphere: With derivatives, individual traders can place enormous volumes of bets on the movement of market variables.

Especially those derivative transactions involving short-selling, credit Financial Derivatives and Responsibility 221 default swaps or the speculation on food prices have often been said to be risk-generating, market-destabilising and welfare-reducing. Also, it is often assumed that speculative derivatives trading used for gambling purposes may increase the risk-bearing of both contract parties, just as gamblers increase their risk by betting. There is empirical evidence that this is likely to result in increased market risk, reduced investor returns, price distortions and bubbles that diminish social welfare. Definitely, more research is needed on the risk-structure of different derivative forms and critical concerns have to be checked closely.





Although the second guideline addresses in particular the behavior of market participants, it seems unrealistic for individual parties to be able to assess which derivative strategy might be risk-generating and which might be risk-dispersing because they only play a small part in the global system of risk. Institutional regulation is needed to make sure that traders only take over the risks they are able to bear. This can be achieved by demanding risk-adequate collateral such as margin deposits, on exchanges as well as and most importantly on OTC-markets.

Transparency through oversight Third, we need to establish transparency through regulatory oversight. In general the writer of the derivative contract doesn’t know the identity of the current owner of the contract. In addition to that, the regulator or the state agency, typically the central bank, that is in charge of macro-prudential supervision doesn’t know it either. Subsequently, it is impossible at this point to determine whether the current distribution of risk inherent in the derivative contracts is systemically stabilising or destabilising and whether the owners of the contracts are too interconnected or too big to fail. Very often, it is argued that it is useless to regulate derivatives any further, as traders always find a way to circumvent regulatory acts. Furthermore, it may seem questionable whether regulatory institutions charged to oversee transactions and to foresee systemic risk can realistically accomplish their task as even institutional investors 222 Trust and Ethics in Finance and rating agencies failed to do so prior to the crisis of 2007/08. It is self-evident that systemic risk cannot be completely prevented from occurring, neither by securities regulators nor by financial market authorities. Transparency, expertise and resources are needed to analyse and to determine which risks are ethically acceptable and which are not. Still, this must not prevent us from trying. There is an ethical imperative to gather and share information and to set up regulatory institutions to monitor systemic risks created or dispersed by financial instruments and to alert market participants if a buildup of systemic risk is likely to occur.

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Conclusion

Derivatives may improve the allocation of risk, but there is no guarantee that they will. There are certain negative events such as a financial crisis or catastrophe that must not be risked and ought to be prevented.

Up to now, a qualified ethical analysis of the acceptability of aggregate risk generated on financial markets is still lacking. This is probably one of the major reasons why so many mistakes have been made in the management of financial risk. Further research is required by scientists as well as finance practitioners and professionals in order to find out which financial transactions on the microethical level pose a cumulative risk to the well-functioning of the entire system.

The guidelines presented above (1. Avoidance of systemic risk, 2.

Distinguishing risk-generating from risk-dispersing instruments, 3.

Transparency through oversight) do not claim to be complete. The aim was to clarify the importance of the tasks and to show that solutions are urgently required. Integrating these guidelines into theory and practice would help market participants understand that financial risk can pose massive threats to the welfare of the system and of society as a whole.

Taking risks responsibly is part of a necessary framework for promoting ethics and integrity in finance.

INTERNATIONALISM, INSTITUTIONS AND

INDIVIDUALS: SYSTEMIC CHANGES FOR

A SYSTEMIC ETHICAL CRISIS

–  –  –

It was 2006, when the world still celebrated the heady days of everrising property values, ever-rising equity values, and ever-rising bonuses for the investment bankers, hedge fund managers and private equity captains who made the good times happen. The head of McKinsey’s Corporate Performance Center in New York was in the Wharton School giving a presentation on “The Tao of Finance”. There was a reverent hush as the students eagerly took notes on valuing companies. No one would have imagined then that the good times would roll to an end just one year later.

What is the way of finance?

I found it interesting that he chose the Chinese word “Tao”. In modern Chinese, the character translates as “way” or “path”. Perhaps the current financial crisis could have been averted if the hordes of business school students eager to find their place on Wall Street had had a differTrust and Ethics in Finance ent conception of “The Tao of Finance”: The fundamentals of finance should be founded on ethics, and not just on Corporate Valuation 101.

Finance is built on a complex social system facilitating the exchange of goods and services that are often abstract and intangible. Wealth in such a system is built on the interplay of trust and ethics. As such, ethics is as important in establishing the modern financial system as CAPM (Capital Asset Pricing Model), DCF (Discounted Cash Flows), or any other modern valuation techniques so emphasised in business school.

They are like the Yin and Yang of the financial world, both are essential for harmony to exist.

The enormity of the current global credit crisis reveals something fundamentally wrong with the financial system. For a field meant to create wealth and that succeeded at doing just that for so many years, it has suddenly given way to a rapid and massive destruction of wealth. And this impact is being felt not just on Wall Street, but also on Main Street, which now faces massive retrenchment after years of heady growth.

The current financial crisis is a major challenge, and to be fair, the crisis is not just the fault of the financial industry, even if at the World Economic Forum’s “Summer Davos” in China, I watched Morgan Stanley’s renowned Asia Economist, Stephen Roach criticise poor regulatory policies, such as the Fed’s low interest rates, as a cause of the current mess. While astute in his analysis, he misses the point of the public’s outrage: people want to know that we can trust the financial industry and the financial elite to act in the public’s interest, instead of requiring an adversarial government watchdog to make them behave.

Systemic and widespread ethical failure

Banking has undergone incredible changes in the last 30 years. Investment banking, a segment of the financial system, exemplifies this transformation. In 2006, I met Joseph R. Perella, a former Morgan Stanley investment banker and an industry legend, just as he was setting Internationalism, Institutions and Individuals 225 up a new investment banking boutique. He claimed that relationships between investment bankers and their clients have changed from one built on trust to one that is commoditised, arms-length, and ruled by caveat emptor.

More broadly, investment banks themselves have became giant trading machines, piling on layer upon layer of complexity on an already opaque system, making the role of ethics all the more important in a system increasingly reliant on self-policing.

The current crisis reveals that the financial industry has failed this ethics test. The collapse of Madoff’s $50 billion Ponzi scheme is an extreme example of a broader abrogation of corporate responsibility in the financial sector. UBS’s alleged role in helping its US clients to evade taxes reveals a company that aggressively chases profits at the boundaries of the law. Most pertinent to today’s financial crisis is the aggressive selling of collaterised debt obligations (CDOs) that placed subprime mortgages in the hands of investors who are ill-equipped to monitor and evaluate the actual risks of their investments.

Some people in the financial industry argue that such relationships come with caveat emptor, “let the buyer beware”. While such arguments might hold sway in a court of law, they offend the general public who trust the financial system, and expect this system to have a certain level of ethics and responsibility. Profit seeking has to happen within the bounds of corporate responsibility. Firms exist because they have a mandate from society to steward society’s wealth. In return, they is responsible to society, in ways that go beyond simply obeying the law.

Multi-level solutions

The widespread ethical failures of the financial industry call for equally broad-reaching changes to the industry. In looking at Madoff, we witness an individual at the epicenter of a financial fraud. In examining the sub-prime mess, we witness institutions who fail at putting their 226 Trust and Ethics in Finance clients first. In studying UBS, we witness an international clash over the meaning of banking secrecy.

The ethical problems in finance are multi-dimensional, with causes situated at different levels of corporate organisation. This means that the comprehensive solution we need should comprise three levels: the individual, institutional and international. Each of these levels exerts a different set of pressures on ethical decision-making. The following analysis defines how the organisation and composition of the financial industry at each of these levels poses systemic challenges to ethical decisionmaking. It then outlines solutions to ethical challenges at each level, with the aim of creating an interlocking system that reinforces ethical decisions made by individuals, firms and the entire financial industry.

The internationalism of financial firms

The rise of international firms, whether pursuing a multi-domestic or transnational strategy, resulted in firm assets that are embedded in different locations. In turn, these assets are embedded in the local legislative and cultural context (Yip, 1989).

Financial firms in particular are some of the world’s most globally oriented firms as they deal with footloose capital – even under present circumstances, capital is an incredibly mobile asset.



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