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In the recent few years the emphasis in the discussions relating to ethics and finance has been a natural consequence of the high-leveraged investment and the excessive risk taking by banks, which were among the causes of the financial crisis of 2007 – 2009. The prevailing sentiment was that the financial system was on the verge of collapse and the subsequent efforts of central banks, financial regulators, governments and other market participants have been focused on designing a new framework to increase the stability of financial markets. As Lehman pointed out in 1988, the mechanisms of financial intermediation create “the majority of interesting philosophical questions about corporate capitalism” largely because financial institutions accumulate and manage particularly large funds and require the participation of increasingly sophisticated intermediaries. Against this backdrop, it is not surprising that among the vast array of topics in financial ethics, the most urgent 48 Trust and Ethics in Finance issue to be addressed is the ethical dimension of the recent failure of financial markets and to what extent ethical theories might be pertinent in designing the financial markets of tomorrow.
Preliminary remarks One of the main caveats in the discussion about the failures of contemporary finance is that participants speak different languages. Nielsen (2010) highlights that many modern economists “separated the study of economics, evolutionary forms of capitalism, and structurally related ethical issues, such as ‘monopolistic practices’ from ethical judgements about those issues”. It became a rule rather than an exception to present economic models in the form of elegant mathematical equations without mentioning ethical dilemmas, even on the list of omitted topics. At the same time, as Haakonsen (2002) put it, in a brilliantly concise formula, “modern moral philosophy is primarily the hunt for a universally normative doctrine”. For an economist not overly acquainted with the history of ideas, the question “what is ethical finance?” is far from being trivial.
On what grounds can we base the ethical judgement of financial markets? Shall we adopt a deontological or teleological perspective? Can we overlook that the perception of finance has varied across the centuries largely due to the amalgamation of social practices and religious views?
A useful formula to overpass this conundrum is to begin with underlying assumptions that will be simple enough and acceptable for the largest possible audience. Two essential elements of Aristotelian virtuous ethics seem to carry a noteworthy common denominator: happiness or human flourishing (eudaemonia), as the ultimate goal (telos) of human actions, and the definition of happiness according to certain virtues.
It is worth highlighting that Aristotle considered that virtues need to be exercised. In this respect, virtues can be compared to skills: one cannot acquire them only by following a class or reading books. To become a skilful car driver one must drive a car on the streets.
Ethics: A Diet 49 Although not completely free of legitimate criticism,1 this dual perspective of telos/virtues will guide us through the rest of the text.
Another question that needs to be addressed is the nature of the contemporary financial sector. According to Biais, Rochet and Woolley (2009), technological change and inflow of resources and skilled workforce, together with market liberalisation, enabled creation of new techniques (securitisation) and new strategies (hedge funds, private equity funds), which deeply transformed the industry. Nielsen (2010) advocates the idea that high leverage is a major characteristic of today’s financial landscape. In addition, one must think about the pace of globalisation of the financial sector, which matches, if not outperforms, the pace of trade globalisation. It has certainly contributed to the spread of risk across the world; but while previously, the consensus was that this process would help manage the risks and losses, it appeared that globalisation was the nexus that transformed local financial turbulences into a global one.
I find it appropriate to elaborate on the groundwork of ethics in finance because we believe that too often the public tend to deal with problems as they surface, i.e. by focusing on the scandals related to fraud and deceit without paying too much attention to the increasingly complex nature of financial markets and their role throughout history.
In the remainder of the paper, I argue that the only realistic approach to judge the financial markets is teleological: financial markets contribute to the positives of life when their functions perform correctly and efficiently. Purely deontological ethics have never been applied into finance. We live in a world of regulations and compliance. I therefore outline a simple framework aiming at improving the functioning of financial markets by fostering financial markets’ stability. At the same time, simply complying with regulations is not sufficient to develop virtuous According to Schopenhauer “It is Kant’s great service to moral science that he purified it of all eudaemonism”. The attempt made by the Ancients to prove that virtue equals happiness, “was like having two figures which never coincide with each other, no matter how they may be placed”. (“The Basis of Morality”).
50 Trust and Ethics in Finance behaviour. I will argue that all market participants should engage in a dual process of education (due to high rates of financial illiteracy in the society) and dialogue over the division of the financial industry in contributions to the common good. I am aware that this analysis shall apply mainly to developed countries even though some conclusions may be relevant for emerging countries as well.
Incentives versus moral motivation
The famous answer of James Tobin is that economics, in one word, is about incentives. Relatively early, economists developed the idea of homo economicus and tried to understand what forces drive his behaviour and motivate his choices relating to work, consumption, and leisure.
In the vast majority of economic models it is assumed that individuals are self-interested and they behave as if they were maximising a certain utility function under existing constraints. This echoes a simplified version of utilitarian ethics, as advanced by JS Mill. There are, of course, models aiming at understanding altruistic behaviour, models stressing imperfect information of the economic agents and a plethora of other deviations from the homo economicus ideal-type. There have been even attempts to include Kantian ethics into formal economic reasoning but without too much impact2. However in general, economic models ignore the question of moral motivations behind agents’ decisions.
The following moral motivations according to three major schools of thinking about ethics; Aristotelian theory of virtue, Kantian deontology and utilitarianism of John Stuart Mill, were investigated by Colle and Werhane (2008). They found that Aristotle and especially Kant asserted Laffont (1975) established a utility function in which an individual maximises its utility according to the Kantian principles (act as if you wished that your actions become a universal law). White (2004) argues that homo economicus can follow imperfect duties but firstly, he does not attempt to model it and secondly he substantially weakens Kantian ethic theory.
Ethics: A Diet 51 that the moral motivation must unavoidably stem from intrinsic motivations of each individual. On the other hand, Mill asserts two options, the individual is motivated by the need to satisfy external requirements or it abides to internal motivations; he undoubtedly assigns moral superiority to the latter. Aristotle, Kant and Mill agree also on the fact that human life has an aim (although they differ when it comes to defining this aim), which implies that a human being must use reason in order to be capable to understand this ultimate goal.
Moral motivations in the ethical system are the equivalent of incentives in economics and in both cases one must assume that individuals are endowed with some form of reason. If we try to apply this to financial markets, one should immediately see that we face here an intellectual conundrum. How can a balance be met between authorities implementing a system of surveillance and punishment in order to obtain ethical behaviour from the market participants with the need for an intrinsic moral motivation behind human acts?
Clearly, compliance with rules and regulations is not enough to establish whether an act is ethical or not. In particular, within the Kantian perspective this is not only insufficient but is insignificant as to whether we abide by the existing law or not. Kant would argue that a merchant (or a banker) that applies a fair and equal treatment to all its clients because he knows that this will achieve optimum behaviour and being unlawful would be harmful for his business does not act morally. Only good will can be discerned as good, without restrictions. We believe we do not risk too much by stating that contemporary finance authorities would never rely solely on the faith that financiers will follow Kant’s categorical, imperative or Aristotelian virtuous ethics.
Today, no one seriously questions the idea that markets are imperfect and need corrections in certain areas or circumstances. Many people are calling for more and/or better incentives for the market participants. In reality, various institutions are in charge of regulating and controlling fiTrust and Ethics in Finance nancial markets3. By multiplying the restrictions and increasing supervisory bodies we are hindering the development of virtuous character but in contrast we admit that potentially better supervision may bring us closer to the objective, which is better functioning of the financial market. This approach could be classified as teleological since it favours the assessment of the behaviour with reference to its goals. However, what remains to be determined is by which categories exactly should we judge financial markets? This requires a short enquiry into the roots and history of the financial industry.
Teleological approach – how to judge financial markets?
It should never be forgotten that according to conventional economics the role of financial markets is to allocate available resources to their most productive use. Another role, less emphasised but equally important, is to redistribute and allocate risks from those who have riskaversion to those who can manage risks. But the extent to which it was understood is questionable. Many people claim that human misery and degradation are caused by financial institutions and not by lack thereof.
The church’s ban on charging interest beyond the principal value of a loan (usury) is symptomatic of some prejudices about finance. Interestingly, the condemnation of excessive interest fostered by Dominican and Franciscan friars in the thirteenth century began with a period of sharp rise in interest rates, due to increasing money supply. The latter was a direct consequence of the discovery of new silver mines in Germany (Mews and Abraham, 2007). Eventually the ban was never rigorously applied because of many exceptions being approved. Investment in partnerships and early forms of joint ventures and profit sharing were not forbidden. Neither was charging penalties for late repayments of the Still, many people are frightened by globalising financial markets mainly because, as Paul Krugman once put it, “it epitomizes what they dislike about markets in general: the fact that nobody is in charge”.
Ethics: A Diet 53 principal. St. Thomas Aquinas had already a vague understanding of credit risk when he accepted that there might be limited legitimate compensation for potential loss to capital incurred by the lender (Mews and Abraham, 2007). But the idea that, for example, a lender might charge the borrower because of the opportunity cost4 of not investing in a partnership, in land or in commerce proved to be too controversial for the majority of thirteenth century theologians (Munro 2002). The consequences were devastating especially for the poor, who were obliged to turn to small, unofficial lenders, loan sharks in today’s terminology, who were charging exorbitant interest (perhaps a risk premium for living under the constant threat of God’s punishment).
It emerges from this brief description that critics of usury could hardly accept the existence of specialised financial intermediaries while they were favouring investments in business projects and profit sharing.
More generally, the hostility towards financiers across the centuries of our history was rooted, as shown by Ferguson (2009), “in the idea that those who make their living from lending money are somewhat parasitical on the ‘real’ economic activities of agriculture and manufacturing.” Ferguson’s financial history of the world offers a compelling description of how the invention of banks contributed to the cultural and economic flourishing of Northern Italy in the late Middle-Ages, how the invention of the stock exchange and central banking fostered the rise in trade and military power of the British Empire and how in general, countries that are now among the richest in the Western world, were those that developed banking, insurance and corporate finance systems relatively early.
Certainly, it would be simplistic to assume a linear relation between the pace of financial innovation and development, however, the vast majority of academic economists agree that there is a statistically significant and positive correlation between the development of the financial sysInteresse – which was a root of word “interest” and was derived from Latin by jurists in Bologna 54 Trust and Ethics in Finance tem and the pace of economic growth (for an excellent review see Levine 1997).
We tend to forget all of this during the periods of financial turbulence when we paradoxically think that finance is a source of instability rather than stability and innovative financial products are weapons of massive destruction. There are some easy explanations of this phenomenon. The financial crisis of 2007-2008 caused massive job losses and deterioration of the quality of life for many people. But what we also know is that financial markets have always known booms and busts, as did emerging economies on all continents. Crises, defaults and recessions occur on a regular basis, as showed in the influential book by Reinhart and Rogoff. Banks, monetary institutions and governments tend to believe that due to better-informed policies, enhanced management tools, technical progress and many other factors, they will be able to avoid past mistakes. Crises, caused by a burst of the asset bubble, are likely to repeat themselves in the future because, as highlighted by Robert J Shiller, who wrote extensively on asset bubble formation, they are impossible to predict with accuracy.
Besides, economic difficulties are also due to other factors, among which I would mention one: the unprecedented pace of growth of populations and economies. As showed by Jeffrey Sachs in his recent article “Need Versus Greed”, the world’s output grew from USD 10 trillion in 1960 to USD 70 trillion today. It helped many people come out of poverty. As a consequence, the planet’s resources and commodities (being the most striking example) are being depleted at an alarming rate. Sachs claims that in the last few years, the greed, not only of bankers, but also of the Western countries, which consume a very large fraction of the world’s resources to maintain very high standards of living, is the main culprit. What is the role of financial markets in this? Financiers alone cannot address all the development issues that the humanity is facing.
Yet they can assure more economic stability and they should increase Ethics: A Diet 55 their awareness of the ethical challenges in the globalised, highly leveraged world. Ultimately, this is what they should be accountable for.
Diet for financial markets
Using our Aristotelian dual telos/virtues framework, a diet for financial markets should involve four building blocks: