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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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Debate Incentives Education Targeting Adequate incentive structures and proper targeting of products are designed to curb excessive risk taking and therefore achieve the goal of better stability of the financial markets. At the same time, we believe that debate and education (of all market participants) are necessary in order to develop virtuous behaviour among the market’s participants.

Two things need to be highlighted before going into details: firstly, I prefer evolution to revolution and we are of the opinion that financial markets need a therapy after the shock of the sub-prime crisis rather than a shock therapy. Secondly, many of these prescriptions are already being discussed and even implemented by the authorities (in particular with respect to incentives) and in those cases our proposals are intended to cherry-pick the key areas and to suggest further improvements that are deemed necessary.

Incentives I begin with the discussion of a few necessary improvements of the regulatory framework. This section might cover a vast array of topics that we are unable to enumerate in this restrictive format. We would like to focus on some incentives pertaining to main structural issues identified earlier: very high leverage and excessive risk taking.

56 Trust and Ethics in Finance Set of recommendations, now known as Basel III, represent a step in the right direction, in particular in the areas of liquidity requirements.

However, with regard to capital adequacy regulation, the recommendations stand halfway; they fail to address a number of critical issues that contributed to the recent crisis.

Firstly, the development of credit derivatives was used by banks to effectively transfer credit risk to third parties and allowed them to reduce their capital requirements. In the paper for the BIS conference, Duffie (2008) argues that banks transferring credit risk have less incentive to monitor the creditworthiness of the borrower. It makes it possible to maintain larger portions of illiquid and/or very risky assets. The result of these practices was to raise “the total amount of credit risk in the financial system to inefficient levels”. Secondly, risk calibration neglects the systemic risks to which financial institutions are exposed. The domino effects of the failure of a major bank in the market were well documented during the recent crisis. Thirdly, our measures of credit and market risk are imperfect despite evidenced improvements and being stated as fact rather than criticism. The measuring of risks stemming was inadequate, for example, from correlations of credit risks in mortgagebacked securities. Two latter arguments are advanced in a very interesting paper by Hellwig (2010). Given the above, there are legitimate doubts that new capital requirements will effectively reduce the leverage.

The solution to this would be introducing non-calibrated, crude measures of leverage in addition to current capital adequacy measures.

Although Basel III initiates leverage ratios from 2013 (as an experiment), they seem to be far too prudent. A careful assessment of the economic impact of such measures must be performed first, but equity/asset ratios of 8-10% would be much more efficient in preventing bank insolvencies and costly bailouts.

Ethics: A Diet 57 One has to bear in mind that large and complex regulations, such as Basel III, certainly have an economic impact on financial intermediation and play a key role in the development of the economy (see the study of Basel III prepared for BIS). Reducing lending capacity of banks and/or making costs for lending higher will most probably translate into an economic slow down. Critics of Basel III, like Hellwig, argue that reducing leverage, restricting moral hazards and lowering systemic risks in the financial system, will result in lower risk premiums being asked by equity investors. Thus, in fact, the increase of the cost of lending will be much smaller and the benefits in terms of system stability will be significant. This trade-off, if there is one, must be a matter of political choice.

Apart from capital regulations, the attention of the public was on the compensation levels of executives and more generally senior financiers across all sectors of the industry. The argument usually goes that it is unfair for bankers to receive large fractions of the profits when the economy is doing well but the costs of bailing out financial institution has to be borne by taxpayers (which by the way amplifies the moral hazard problem). The concern with executive pay is legitimate yet the issue that needs to be addressed is whether compensation packages offered to bankers (executives in particular) provide them with an optimum incentive structure from a risk-stability perspective. This is an unorthodox view. Cai, Cherry and Milbourn (2010) explains that from a classical perspective, the calibrating of the executive’s pay scheme is “aligning managerial incentives with those of shareholders”.

There are few chances for the return of Medici-style family-run banking. The principal-agency problem in the case of the financial industry is amplified by a number of factors such as an increasingly high leverage, deposit protection schemes, explicit or implicit guarantees of the state or access to emergency liquidity windows by the central bank.

Kandel (2009) argues that executive pay might be substantially reduced 58 Trust and Ethics in Finance without hampering the proper incentive structure. Some economists, for example, Gehrig, Lutje and Menkhoff (2009) defend the hypothesis that the relation between the size of variable, performance-based remuneration of investment fund managers and their willingness to take risk is insignificant. However, there was a general consensus that remuneration packages encourage more short-term profit maximisation, for example, by increasing leverage, engaging in aggressive trading or loosening control over credit origination standards.

But the key issue is the following – if managers maximise the shareholder’s utility, they do not necessarily take into account the interests of depositors, debtors and other stakeholders, not to mention the issues of general market stability. The general audience being authorised to impose on financial institutions the implementation of compensation structures that promote overall system stability is not evident. Financial stability is highly desirable and probably optimal for society as a whole but the means to achieve this goal must be debated.

What public authorities could propose is the introduction of financial stability criteria to calculate the variable part of executives’ compensation. It could be recommended (but not imposed!). It is for the banks to establish internally in advance thresholds for leverage, stable funding ratios, overall market/credit risk levels and adjust the compensation accordingly if the objectives are met or not.

Targeting In order to perform correctly one of the major roles of financial markets, i.e. the redistribution of risks, market participants must distribute products that are adequate to the client’s financial literacy (we address the issue of literacy in the subsequent chapter). The application scope of adequate targeting principle is very wide, for example, offering brokerage accounts to retail clients or extending loans denominated in foreign currency to clients having revenues in domestic currency means exposing them to risks they may not necessarily be able to manage. This is Ethics: A Diet 59 another field of financial regulation that has been subject to careful examination, and significant progress has been made. From a European angle, the Markets in Financial Instruments Directive (MiFID) is one of the best examples of this. One of its key objectives is to improve the categorisation of clients according to their ability to understand financial products. Three categories apply; retail clients, professional clients and counterparties.

The last category encompasses other financial institutions. Let us focus on the first two that should be far more risk-adverse. The definition of a professional client is that it must have “the experience, knowledge and expertise to make its own investment decisions and properly assess the risks that it incurs”. The remaining clients are retail clients, for whom we assume insufficient knowledge to take informed investment decisions. They enjoy, at least in theory, the highest degree of regulatory protection. However, the alarming failure by banks to assess the credit risks had a direct impact on customers purchasing even basic retail banking products. Was it the fault of retail customers or the banks when in some countries people were massively granted mortgage loans they could not afford (sub-prime)? The question is rhetoric, given the massive asymmetry of knowledge and experience between the banks and the low-income borrowers. Another example is offering clients products with embedded currency risks like loans denominated in foreign currencies to people who cannot hedge the risk (they have no access to the derivatives market).

The same analysis might apply to some extent to professional clients.

As a matter of fact, the distinction between professional and retail client is often blurred. Professional clients might be, for example, medium or large corporations who are clients of banks. Those firms are supposed to be managed by financially literate managers who are able to identify and tackle potential risks but the reality is somehow different. In 2008/2009, when the markets were nervously selling assets in the emerging markets, 60 Trust and Ethics in Finance pushing their currencies down, sometimes dramatically, one of the key topics in Poland were currency options. It appeared that Polish companies had entered into currency options with banks without necessarily having any underlying transactions to hedge and bet against apart for the appreciation of the Polish currency. In many cases the purpose of this was purely speculative and it exposed companies to severe losses. The line of defence for banks was that they were dealing with professional clients. Yet in a number of testimonies to the press, both employees of the banks and clients confirmed that companies that purchased the products were not sufficiently aware of the risks they were taking. The line between unethical behaviour and poor business decision is often very thin but in this case the structure of incentives was clearly inadequate.

Bank employees had strong incentives to sell because their final salary depended on the volume of products sold, so they were emphasising to clients only the potential gains.

An alternative approach is to amend the structure of incentives in order to promote better targeting of financial products. There are no easy solutions to this problem but financial institutions should be encouraged to take a more conservative approach when assessing the ability of the client to manage risks. From a regulatory perspective, the incentives might come from financial services authorities. A good example was the reaction of the Polish Financial Authority (KNF) to the widespread practice of lending in foreign currencies to retail clients. According to “Recommendation T” banks must perform stress tests of the borrower’s ability to service its debt under the scenario of a shift of interest rate and foreign exchange rate depreciation. It also recommends a threshold of debt repayment expenses in relation to monthly net income. Although stress testing is imperfect, implementing these measures is a relatively easy way to improve adequate targeting of financial products.

Ethics: A Diet 61 Debate, education These two elements are presented together because there are some obvious synergies to be achieved between the two. Debate on the ethical issues in finance should take place within the financial institutions but also in the public realm and involve all types of social actors. One of the latent effects of such a debate will be an increased awareness of ethical issues within society.

Almost all of us are clients of financial institutions and we depend on them to satisfy our basic needs. As echoed by R. Hinde (2007), when the competition mechanisms of the market work correctly, “the ethical demands of the public can affect what the firm does”. Naturally, how much the firms are changing their behaviour depends to large extent on how many customers are aware of the ethical issues and whether they decide to take direct action. Some critics would also say that this is inscribing ethical necessity into the logic of market competition. However, I believe that this is a necessary step to develop virtuous behaviour, which in the future will stem more from intrinsic moral incentives rather than regulatory or market constraints.

One of the key constraints is the relatively low financial literacy of the society. Lusardi (2008) made a very convincing case about the current level of illiteracy, highlighting that ignorance of basic financial concepts may be linked to poor savings level (including pension savings), inadequate borrowing decisions and lack of participation in more sophisticated forms of investment. Against this backdrop, taking informed decisions is very difficult. To address this issue I propose the following. Fundamentals of finance and economics should be introduced into high schools at a relatively early stage as a mandatory subject. The objective of this would be to provide all students with a basic knowledge of financial products that they are most likely to come across as adults (savings accounts, mortgage loans, pension plans, insurance etc.).

62 Trust and Ethics in Finance At the same time financial institutions also should engage in a programme of education for their employees, which should not be limited to basic e-learning programmes with the compliance department. One day of the year should be proclaimed as a Day of Ethics in Finance. The key feature of the Day of Finance would be that it must be prepared in advance. Employees should form working groups and research selected topics in ethics, which should involve the study of classic texts and the analysis of market practices. The results would be presented on the Day of Finance. Other tools could be developed internally by companies, which should be given a flexibility to adapt this exercise to their specific internal characteristics.

Administratively, the Day of Finance could be co-ordinated by central banks or financial authorities; it should not be imposed on financial institutions but rather recommended as good practice. In addition, central banks could put additional pressure on other banks by organising a series of seminars, lessons at schools or advertising campaigns. An integral part of the Day of Ethics should be a round-table debate organised, for example, by national broadcasting companies and well advertised among the public, where different social partners might debate ethical issues. The main objective of the round table would be to promote discussion in an attempt to build a common language with regard to those issues. One of key topics should be the responsibility of the financial industry to promote sustainable economic growth.

Bibliography Biais, Bruno, et al, 2009. “The Lifecycle of the Financial Sector and Other Speculative Industries” IDEI Working Paper, April 2009.

Cai, Jian, et al., 2010. “Compensation and Risk Incentives in Banking and Finance”, Economic Commentary 2010-13, The Federal Reserve Bank of Cleveland.

de Colle, Simone/ Werhane, Patricia H., 2008. “Moral Motivation Across Ethical Theories: What Can We Learn for Designing Corporate Ethics Programmes?” Journal of Business Ethics 81 (4), 2008, 751-764.

Duffie, Darrel, 2008. “Innovations in credit risk transfer: implications for financial stability”, BIS Working Papers 255, July 2008.

Ethics: A Diet 63 Ferguson, Niall, 2009. The Ascent of Money. A Financial History of the World, Penguin, 2009.

Financial Services Authority, background information on MiFID, www.fsa.gov.uk/pages/About/What/International/mifid/index.shtml Gehrig, Thomas P. et al., 2009. “Bonus Payments and Fund Managers’ Behavior: Transatlantic Evidence”, in: CESifo Economic Studies 55 (3-4), 2009, 569– 594.

Grosh, Paul/ Vardy, Peter, 1999. The Puzzle of Ethics, second edition, London:

Fount, 1999.

Hellwig, Martin, 2010. “Capital Regulation after the Crisis: Business as usual?” Preprints of the Max Planck Institute for Research on Collective Goods, Bonn 2010/31.

Hinde, Robert A., 2007. Bending the Rules, Oxford University Press, 2007.

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