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64 Trust and Ethics in Finance
The purpose of cash management is to ensure that companies have the cash they need at the right moment, and at minimum cost. To do this, companies use a range of measures and techniques relating to cash planning, decisions on short-term financing and investment, management of relations with financial bodies and management of financial risks. Other key aspects are monitoring and analysis of receivables and payments management, as well as corporate culture.
By its very nature, this business concept is a complex one, probably because it lies at the heart of corporate management, for its decisions directly or indirectly affect and are affected by (a) all other areas of the company, whether commercial, structural or social, and (b) other companies with which it has relations, and even society and the environment.
Decisions that affect the whole society Such measures, and above all decisions on cash holdings, thus affect and are affected by groups of stakeholder, yet financial cashTrust and Ethics in Finance management techniques are based on selfish assumptions and behaviour on the part of companies and their managers and are sustained by distrust of other players. This results in unilateral decisions based on personal goals, which can scarcely generate value for all those involved. In this connection it may be said that financial management, and specifically cash management, include a major ethical component, since unequal conditions, information asymmetry and opportunistic efforts to maximise short-term results may have an adverse financial impact on other economic players or other interest groups.
A twofold problem arises in connection with cash management. On the one hand, as already indicated, cash management affects not only the company’s own decisions but also third parties, and ultimately the whole of society. Today’s crisis has highlighted the link between companies and banks, since, although the crisis had its origins in a combination of greedy operations involving junk mortgages with a complex system of financial products in the banking sector, the resulting chain reaction has led to the most serious cash problems in history. The scale of this can be deduced from the fact that practically every company now describes its short-term financial position as tricky or indeed disastrous, as witness the large increase in company failures around the world.
At the same time, in order to have an optimum impact on parties’ medium- and long-term interests, solutions must be based on mutual trust, and hence on ethics. Yet the need for this ethical basis may come to be challenged by a general opinion – shared by academics and professionals – that this is merely a management problem. But even then it may be argued that there are ethical issues involved, since financial and cash-management strategies are based on selfish approaches. For instance, one of the most important cash-management strategies, advocated in most books and texts on finance and accounting, involves paying suppliers later without damaging relations with them and requiring customers to pay sooner without substantially reducing sales (Gitman et Ethical Cash Management? 67 al., 1976). Yet this short-term financial strategy, which is based on companies’ cash cycles, does not generate maximum overall value, but a maximum level of own value that cannot be sustained in the long term;
still less does it optimise companies’ cash holdings.
Create value for all Up to now, financial experts and operators have focused on studying and proposing techniques and instruments for optimising cash holdings;
however, in order to achieve this, at least across the board, the unitary approach must first make way for a comprehensive one in which techniques used create an optimum financial situation for all the stakeholders or companies affected by financial operations. To respond to this problem, we need a change in corporate financial culture, which in our view can only optimise overall cash holdings and generate value for all if financial strategies rest on one basic pillar, namely mutual trust. Situations of illiquidity, insolvency and bankruptcy in which companies find themselves must be analysed not only from the point of view of their own corporate management, but from a broader perspective that takes account of the (essentially adverse) impact on the entire group of stakeholders. Thus, and from the point of view trust among interest groups, it may be considered that improved results – social as well as economic – can be achieved for all those involved if cash-holding techniques are based on the notion of mutual benefit and the common good.
Current cash-management and cash-holding techniques are being developed on the basis of financial theories – pecking order, trade-off or agency theory – that are consistent with the goal of maximising shareholders’ interests. They are not, therefore, specifically designed to create value for all stakeholders. Yet our theory may complement rather than conflict with existing cash-holding techniques, for it seeks to create models that maximise value for all the interest groups involved, including shareholders. From the point of view of cash management, this apTrust and Ethics in Finance proach relies on the premise that all the interest groups (both internal and external) affect and are affected by short-term financial decisions and hence by liquidity flows.
Cash holdings: The right level The main purpose of cash management is to ensure that companies have the cash they need at the right moment, the optimum level being the minimum necessary; moreover, studies so far have concluded that companies must main a positive cash level. In this sense it is preferable to hold cash than resort to external finance that costs more because of information asymmetry between companies and outside investors (Myers and Majluf, 1984), problems of agency costs such as underinvestment and asset substitution (Myers, 1977; Jensen and Meckling, 1976) and transaction costs and other financial constraints. Managers must therefore determine optimum cash levels by minimising the cost of obtaining external finance on imperfect capital markets. However, holding cash or its equivalent also raises potential problems. Agency conflicts between shareholders and managers may be reduced if the company has high free cash-flow levels (Jensen, 1986), for managers can put their own interests before those of shareholders. It should also be recognised that excessive conservatism has disadvantages of its own, such as the opportunity cost of holding assets that yield little or no return. Cash holdings create an opportunity cost for the company, for they produce a lower return than that yielded by the company’s productive investments; at the same time, the company may incur transaction costs resulting from the purchase or sale of financial assets, and also suffer tax disadvantages.
Are corporate cash-management techniques ethical?
cause of power and information asymmetry, agreements are reached under conditions of inequality which are justifiable in terms of contract theory but run counter to the interests of one of the parties. Cash management is based on contract theory (Coase, 1937), in which various parties reach free agreements, under the terms of the law, on the times at which debts arising from various economic transactions will be paid. In theory there should be no ethical problem with this approach, as long as the assumptions of equality and perfect capital markets hold true; in practice, however, inequalities between the parties, such as power and information asymmetry and opportunistic behaviour, as well as market failures and opportunity costs, mean that the agreements reached may not be optimal for one – or indeed either – of the parties.
Nevertheless, interest in ethical cash management is not confined (although this would be sufficient) to a theory of equality in commercial relations or in stakeholders’ interests. Thus, and given the role played by cash holdings in cases of insolvency, selfish cash management – as an ethical approach would suggest – may be a key contributing factor to bankruptcy and its various adverse consequences (unpaid bills, dismissals, broken contracts and so on).
In Spain, for example, the current unsustainable short-term cash position has led to mass company closures, doubling the number of unemployed to four million. In the United States 2.6 million jobs were lost in 2008, a figure not seen since 1945. In Britain some 50 businesses close each day, and the situation is no better in Latin America, where unemployment is rocketing and increasingly unmanageable. Specifically, the ILO’s Regional Office in Lima has reported that in 2009 the impact of the economic crisis will, for the first time since 2003, raise the average annual unemployment rate to between 7.9% and 8.3%, which means that
2.5 million more people will be out of work. Liquidity problems are increasing in all countries, and this is one of the factors that are causing businesses to close in such alarming numbers.
70 Trust and Ethics in Finance
A more ethical approach
The financial crisis and liquidity problems are connected, which is why the current crisis has highlighted and, disturbingly, helped tone down the worst predictions about opportunistic behaviour when it comes to cash-management strategy. However, and not only at times of recession and economic crisis, consideration may be given to a more ethical approach to cash holdings, one that is based on collaboration between the various players and may (at least in theory) produce the desired optimum level of cash – namely mutual cash management based on trust.
Such an approach is justified not only in purely financial terms, for it makes cash management easier, but also in ethical terms, for it benefits all those involved and ultimately contributes to the common good. Financially, collaboration between players would lead to debts being paid at mutually agreed times and would reduce financial risks and transaction costs, allowing players to optimise their economic and financial results; and, socially, it would cushion the adverse impact of monetary imbalances, such as unpaid wages, late payment of suppliers, loss of customers and – ultimately – insolvency.
Mutual cash management based on trust
Relationships between economic players and groups with an interest in the company must be analysed and managed carefully. The financial relationship between a company and the players that interact with it will depend on the nature of the various interest groups; thus the company will have different relationships with its suppliers, its customers, the government, the banks, its employees, its shareholders and the community as a whole. One strategy would be to identify the company’s cash operations and then which players are involved, in order to examine their repercussions and so make multilateral decisions that benefit all concerned. Strategic cash operations will be long-term, but the specific Ethical Cash Management? 71 decisions will be short-term, because at any given moment we would be talking about cash holdings.
This will require a change of financial culture so that each company’s cash holdings are henceforth determined by the interest groups, since these will affect and be affected by the decisions the company makes; but at any given moment our starting point should be the operations rather than the stakeholders, in order to ensure that every decision regarding cash is viable.
A potential conflict
Relationships between the various players involved have been studied in the existing literature on cash holdings. This shows, for example, that there is a relationship between companies’ shareholders and their cash holdings. Dittmar et al. (2003) found that, in countries where shareholders’ rights are more fully protected, companies’ cash holdings are lower, although both variables are related to the level of development of capital markets in the country concerned. Other writers (Pinkowitz et al., 2006; Kalcheva and Lins, 2007) likewise suggest that shareholders look for managers who will reduce cash holdings. Jensen (1986) also points to this potential conflict between shareholders and managers, for an increase in cash holdings will increase managers’ power at the expense of that of shareholders. This implies a potential conflict between shareholders and managers over cash holdings, since these may benefit either the former or the latter in the traditional agency dilemma between principals and agents described in agency theory.
Thus, from the point of view of both shareholder theory and stakeholder theory, there may be a clash of interests when it comes to cash holdings. The specific difference is that in the former case (shareholders) we are basically dealing with a problem of governance, whereas in the latter case (stakeholders) we are dealing with a cash-holding problem. Shareholders’ rights, agents’ possible interests and all the other 72 Trust and Ethics in Finance stakeholders’ legitimate rights and interests must also be taken into account.
This conflict matters more than any other cash conflict, for it affects not only cash management but also governance, and so the way in which it is solved may determine how cash conflicts with other stakeholders are solved via the company’s financial policies.
However, this should not be the case in a descriptive approach, for financial policies should be aimed at all stakeholders; but, from a legal point of view, the selection and supervision of CEOs clearly rests with shareholders.
One must wonder what real scope they have to exercise those rights (Boatright, 2008), since in many cases real power is in the hands of the company’s management.
Pursuing a joint interest