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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 EU: Recent initiatives and Proposals”:


De la Dehasa, G., 2007. “How to avoid further credit and liquidity conference crises”: www.voxeu.org.

Ferguson et al. 2007. International Financial Stability. Geneva: CEPR and ICMB.

Levich, et al. 2002. Ratings, Rating Agencies and the Global Financial System.

Washington: Springer.

Mariano, B., 2008. “Do reputational concerns lead to reliable ratings?” See www. voxeu.com.

Perkings, T., 2007. “Misguided or Misunderstood?” Globe and Mail. 7 September 2007. www.theglobeandmail.com/report-on-business/article780146.ece Portes, R., 2008. “Rating Agency Reform”. See www.voxeu.org/index.php?q=node/887.

Reinhart, C., 2008. “Reflections on the international dimensions and policy lessons of the US sub-prime crisis”. See www.voxeu.org.

US Congress, 2008. Transcript: House Oversight and Government Policy Committee. 22 October 2008. oversight.house.gov/story.asp?ID=2250.

256 Trust and Ethics in Finance Appendix: Current Regulatory Framework for CRAs (EU and US) ^




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Today’s world is a world of increasing differences. There are objections to the previous statement, but the World Bank’s figures are selfexplanatory. They point to a scenario whereby extreme poverty of the world’s poorest would have dramatically increased in the past 20 years in Sub-Saharan Africa, whereas South and East Asia have benefited from the phenomenal growth of China and India.

There is overconfidence and a lack of realism in the first world as to how to tackle the situation that worsens day by day. Many individuals in the rich world, who are not directly involved with the difficulties faced by emerging economies, do not realise the depth and severity of the problems the poor encounter, or the degree to which the latter affect the daily lives of millions of people.

No easy solution seems feasible or applicable. There have been, and there are interesting initiatives that, provided their success, could bring first and third world closer together in terms of income, growth opportunities and share of the pie. However although apparently straightforward, these proposals remain simplistic and hard to implement within 258 Trust and Ethics in Finance the present regulatory framework, even if this may be possible on the long run. This situation is exacerbated by the fact that the individual is greedy by definition.

The role of financial economics Finance drives the economy in the developed world. The economic policies of rich economies determine the fate of emerging countries. It seems plausible to find alternatives that can be implemented through regulation in the financial markets of the developed countries, and to change some of the basics that permit their existence and operation.

Capitalism has always been revisited after major crisis or crashes. The Great Depression in the 1930s, the crash of the stock market in 1987, the burst of the Internet bubble in the late 1990s, or the financial fiasco of Enron, Worldcom and Arthur Andersen in the early years of the twentyfirst century, are all examples of situations in which the major players of the game redefined their roles and repositioned themselves. Many people in the first world may not see a crisis in the current environment.

Many may be too optimistic, overconfident, true believers in a process we all label globalisation that brings good to everyone we know, to all around us. Some people could have misunderstood what globalisation really brings to many, wrongly taking for granted that those living in the developing world can access the same sort of opportunities and resources as those of us who live in the rich world.

As in the past, capitalism may need to be revisited. The current trend does not serve the goals set by the UN, which, given the current state of the world, are unlikely to be accomplished by the year 2015.

Jeffrey Sachs, who currently heads the Commission in charge of UN’s Millennium Development Goals, points out: “We can realistically envision a world without extreme poverty by the year 2025 because technological progress enables us to meet basic human needs on a global scale and to achieve a margin above basic needs unprecedented in hisRedefining Capitalism 259 tory.” Jeffrey Sachs is right in the end but he may not have pinpointed the correct means. Vandana Shiva, a writer connected with the participatory economics movement, led by Michael Albert, makes an interesting argument: “To make poverty history, we first need to elaborate a real history of poverty. And Sachs has totally misunderstood it.” The present trend of capitalism will be that of increasing differences.

Inequality tends to increase not only at global level, but also within developed nations. The system is heading in the wrong direction, but still has the virtue to redefine itself. However this will not happen automatically.

Redefining capitalism

The strong connection between financial markets and the opportunities available to emerging economies plays a key role in the search for practical ideas to redefine current capitalism, and manifests the importance of financial economics in the development of this approach. As previously stated, finance is viewed as the main driver of the first world’s economies. Finance has a daily impact on the stability and growth of an economy.

There is already regulation in the financial markets that, through taxation, raises public funds for public spending. If corporations were given an option whether or not to pay corporate or dividend tax, they would definitely choose not to, based on the maximisation of the present value of their future cash flows. Or equivalently, they would adopt the one strategy that most benefits their shareholders, the one that maximises their equity.

Similarly, corporations in today’s world tend to respect current regulations, but are able to skip ethical codes of conduct, always aiming at maximising their profits.

260 Trust and Ethics in Finance One of the key strengths of current financial markets is the financial possibilities it opens to public corporations through the issuance of stock or corporate debt.

The concept of financial rating is key to a public corporation, because it determines the cost of capital it will incur on whatever funds are borrowed from investors. The rating agencies impose strict constraints in determining certain ratings that are indicative of the financial strength of a corporation, or alternatively viewed, the established financial policies. Additionally, auditors make sure a public corporation’s financial statements meet international standards and are trustworthy.

Hence there is a system in place with which the modern corporation has to comply. This system has undergone much evolution over the years, without reaching perfection. A corporation’s only approach is to adapt to the regulation and the set of rules established by regulators and rating agencies. Top executives in large corporations work hard to be transparent, to not use confidential information to their own advantage, to immediately communicate whatever news may arise, either good or bad, to the financial community.

There is a growing trend in the corporate world to adopt a code of ethical conduct that includes respect for the environment, flexible working conditions, trade-offs between work and family, etc. However a firm is absolutely free to adopt such codes or not, as these have no repercussions from a financial point of view. Briefly stated, a firm’s financial rating will not change whether or not the company is ethically responsible. Today’s financial markets only reward the financial manners of a corporation, with the ethical dimension being considered as irrelevant.

The need for an ethical rating

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to third-world economies where deplorable working conditions reign, and that have no strong established ethical regulations. The rich world has succeeded in building a system that works for the first world, but that does not work globally. The system needs to be revisited, and this time the ethical component needs to be addressed.

Alongside the financial rating, companies should have an ethical rating of similar nature that would affect their financing and success in the consumer market, as much as the financial rating does in the financial markets.

Rating agencies would determine the ethical actions of a corporation, whether or not it outsources, how it invests its money, the working conditions of its employees, whether its operating policies respect the environment, what part of its corporate tax is devoted to social action and so on. And there would be (ethical) auditors that confirm whether the corporation complies with the set of ethical criteria established. A globalised economy characterised by the immediate communication of information should not tolerate unethical policies on behalf of corporations.

The statements are strong, since they touch every potential corporation that participates in the financial markets. But if a corporation currently does its homework financially speaking, simply because this is the way to operate within the system, a corporation will similarly do its homework from an ethical point of view, if this is a requirement to remain in the system.

Every potential investor looks at a corporation’s financial rating prior to purchasing stock, corporate debt or derivatives that have the corporation’s stock as underlying asset. The financial rating has become a guarantee for an investor because it is a definite indicator of the firm’s probability of default. The ethical rating would play the same role for the consumer. Investor versus consumer is the key in this argumentation.

262 Trust and Ethics in Finance

The consumer as actor

Products and services would be labelled with a company’s ethical rating. The consumer could therefore know at any given moment whether a company is ethically responsible, and ultimately, consumers would reward or penalise a firm for not complying with the rules of the system. There is research available that links a consumer’s ethical values to his or her consumption habits. Therefore and provided that a consumer does have ethical values, he or she would likely purchase products or services that align with his or her values, ethically speaking. This is why the proposed system is sustainable. In order to be successful in the marketplace a firm would have to be ethically responsible. The better the ethical rating, the better opinion a consumer would have of the corporation, and the more likely he or she will be to purchase a certain product or service.

Multinational corporations would not determine a consumer’s choice. Consumers will rather determine a corporation’s set of operating policies. It’s about reversing the rules of the game. It’s about giving the consumer the power to believe that his or her actions truly affect the state of the world. It’s about only allowing those players that respect the rules to participate in the game. It’s about consumers pushing those corporations that are not ethically responsible out of the market.

There is a success story in certain European savings banks that are required by regulation to devote a high percentage of their net income to social action. And these banks do so because they have to, in order to comply with the regulation. And the effects of their social policies are noticed locally.

Contribution to a development fund

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come, funds that would end up in a development fund. A company may choose not to do so, although by doing so it may obtain the maximum ethical rating and the corresponding consumer reward. It is a trade-off, since what a firm loses by giving away part of its funds is earned through consumer reward.

The money accumulated in the development fund would be managed by a public entity that would only invest in companies that are ethically responsible. Companies that are ethically sound, besides being financially driven, would see their financing opportunities increased. This idea follows from the ethical ratings presented above.

It is possible to picture a world with strong multinational corporations that are ethically responsible. It is feasible to imagine a development fund converted into the largest fund of human history, that only invests in companies with strong ethical codes of conduct, that devotes the rates of return of its investment strategies to development aid, and by doing so fosters ethical operating policies within corporations.

Towards a global sense of justice

Going one step further, let’s suppose that by regulation, the wealthiest are required to devote a tenth of their wealth to a development fund.

If this fund’s principal were to be compared with other large funds, it would be the largest of any funds in the history of financial markets.

Personal wealth over a certain amount should be taxed. The current regulation taxes income and gains on assets, but does not tax personal wealth. Ultimately, nobody should be eligible to possess more than a certain amount of money without being taxed for the monetary resources held. In terms of a global sense of justice, it is simply not sustainable.

And this can and should be accomplished through regulation, with changes to the tax code.

Corporations would be entitled to invest 10% of their net income in a development fund over a certain time horizon, say 5 years. After this peTrust and Ethics in Finance riod expires, the corporation would get the invested money back, and this would be done on an annual basis. The fund would keep the profits linked to the investment strategies, and devote them to development aid.

Rich economies would issue as much as the equivalent of 10% of their GDP in public debt and devote this money to the investment fund.

Again, only the profits from the investment strategies would be used as development aid. Therefore the fund would have a principal to invest in securities that would not decrease over time.

Surplus of rich economies of the world would feed the development fund, whose rate of return would become development aid for thirdworld economies. Personal wealth over $1 billion would be initially asked to contribute 10% to the development fund.

And last but not least, individual investors would be welcome to allocate part of their savings to the fund over a certain time horizon, after which they would get the principal invested back.

Many of today’s individual investors with certain savings on their accounts, either do not invest them and hence keep them in a checking account with either no return or very low return, or invest them in funds that yield small returns that are mostly kept by the investment managers for actively managing the funds (management fees).

These individuals could alternatively invest their savings in the development fund that could have indexed investment strategies in exchange, and would not charge management fees. The individuals would get back the principal invested after the time horizon they chose, the rates of return being kept by the fund, and devoted to development aid.

From the rich to the poor The fund would become a redistribution instrument, from the rich to the poor. With an annual budget equal to the profits of its investment strategies, the fund would distribute the profits competitively among projects proposed to a central committee. The committee would be in Redefining Capitalism 265 charge of allocating the funds. Proposals would be submitted and analysed by the committee year round. In an annual summit, the committee would announce which proposals have qualified for funding. The projects that get funded would be monitored and audited by the development fund’s auditors, who would travel to emerging countries to follow up the development of a project.

The above process guarantees that the development aid is used as efficiently as possible, that through submission, only strong proposals get funding. Furthermore, the audits would also ensure that an organisation does not receive funding again if it has previously been declared corrupt by auditors.

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